benchmarking european power and utility asset impairments...goodwill impaired (more than the entire...

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Benchmarking European power and utility asset impairmentsImpairments at a high in 2013 as utility sector transforms

Contents

EY has been tracking impairments at 16 major European power and utility companies1 since 2010. 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 2010–12 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 fi nancial reports, analyzing the fi ve main factors underlying these write-downs and how they rank in terms of relative infl uence.

Diffi cult conditions persist, particularly in Continental Western EuropeEurope’s leading utilities wrote €32b off their balance sheets for impairments in 2013. 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 infl uence on impairment in 2013. 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 identifi ed as having an impact on impairment (demand, policy and fi nancing conditions) also played their parts. However, their role was less acute and, in the case of policy and fi nancing conditions, was typically localized in effect.

The power and utilities sector is undergoing radical transformation, which contributes to the level of impairments booked by leading European utilities in 2013.

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 + 33 1 46 93 46 16 or [email protected].

Executive summary

2

1. Impairment numbers reach a high in 2013 4

Conclusion 19

2. The story behind the numbers 7

3. Looking forward 12

2Executive summary

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.

Benchmarking European power and utility asset impairments

Facing up to a changing worldThe 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 fl exible and innovative with their business models and service offerings.

Strong investor communication vital as more uncertainty loomsIn the context of this new paradigm, we also look forward to consider a number of factors that may infl uence utilities’ profi tability, and thus impairments.

In the short term, risk and uncertainty will undoubtedly prevail — and that means we see little prospect of impairments being

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.

3

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 confi dence 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 2035.2

2. “World Energy Outlook 2013,” International Energy Agency, 12 November 2013.


4 Benchmarking European power and utility asset impairments

Impairment numbers reach a high in 20131

5Benchmarking European power and utility asset impairments

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.

In 2013, impairments in value were 2.5 times higher than in 2012.

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 2010. From 2010 to 2013, a total €62.7b of value was wiped off, of which slightly more than 50% occurred in 2013. To put the 2013 fi gure 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 2014.

We analyzed the 2013 fi nancial reports of the 16 European utilities in our sample to understand the main drivers of this signifi cant rise in impairment and the lessons we can learn.

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 2012.

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 fi ve companies in 2012. The rise in impairment is fairly signifi cant in some instances. Two of the companies with impairments higher than €1b in 2013 posted only €0.2b in 2012. Aggregated fi gures tell the same story. Over 2010–13, 11 companies in our sample posted impairments for an aggregate amount higher than €1b, compared with only 8 companies during 2010–12.

3. Capital IQ — market capitalization as at 24 June 2014.

1st quartile 2nd quartile 3rd quartile 4th quartile

€ €24.8b €4.8b €2.2b €0.2b

% 77.5% 15.1% 6.8% 0.6%

No company is now immune to impairments. Over 2010–13, only two companies posted impairments totaling less than €150m each, compared with four companies during 2010–12. These two companies posted impairments totaling €113m in 2013 compared with €3m over the 2010–12 period.

Table 1. Impairment breakdown 2013

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 assetsIn 2013, impairment of goodwill reached €9.6b while impairment of assets reached €22.4b or 70% of the total impairments posted in 2014.

Table 2. Majority of impairment is still assets rather than goodwill

2013 2012 2011 2010 Total

Impairment of goodwill

€9.6b €3.9b €1.8b €2.4b €17.7b

Impairment of assets

€22.4b €8.9b €7.5b €6.2b €45.0b

Total impairment €32b €12.8b €9.3b €8.6b €62.7b

Source: EY analysis; fi gures 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 diffi cult regulatory, operating and fi nancing 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.


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 2012. 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 identifi ed that €9.5b specifi cally relate to thermal generation assets(gas- or coal-fi red), €1.5b specifi cally relate to nuclear generation assets, €2.0b specifi cally relate to renewable generation assets, and €1.8b is not specifi cally 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-fi red 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

2013 2012 2011 2010 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


Focus is now fi rmly on Continental Western Europe and the NordicsImpairments posted have increased in every location with the exception of Southern Europe, which was historically the fi rst area to suffer serious impairments and where signifi cant 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 2013. As mentioned previously, adverse market conditions for thermal generation assets (particularly gas-fi red) 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-specifi c4

2010 €2.5b €2.4b €1.1b €0.3b €2.3b

2011 €3.4b €2.7b €1.4b €0.6b €1.2b

2012 €2.9b €5.5b €1.6b €0.6b €2.2b

2013 €2.5b €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; fi gures are rounded.

4. Impairments that could not be allocated to a specifi c region based on the information provided by companies were classifi ed as non-specifi c.


The story behind the numbers 2




Movement in wholesale power prices weighed on utility cash fl ow assumptions, pushing up asset and goodwill impairments for 2013.

Pricing environment: still key and not improving

Particularly in a sector that is driven by fi xed 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 fi gure 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 fi nancial statements.” Later, he states that “the solar boom and the steep decline in the price of hard coal and CO2 emission allowances have put wholesale electricity quotations under pressure. As a consequence, the profi tability of our power plants has recently deteriorated signifi cantly. This is refl ected in the 2013 consolidated fi nancial 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 fi rst half of 2013 were the poor market environment as well as the decline in the wholesale electricity prices below the level defi ned by Verbund for early pricing in of own generation.”6

We have taken a closer look at the annual reports of our 16 tracked utilities to assess the relative importance of fi ve 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 diffi culties faced by conventional power generation, is one of the big stories of 2013, with some companies starting to argue that these diffi culties should be managed through regulation.

The impact of demand is starting to be mentioned on a stand-alone basis, in contrast with previous years, while regulation itself has gone down in the order of factors that infl uence utility decisions to book impairment. However, regulation can still have a signifi cant impact on some specifi c 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 infl uence on impairment in the coming years.

Lastly, fi nancing 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

Utilities

Financingconditions

Pricingenvironment

Policy

Demand

Major driver Important driver Less important driver

Supply

5. Annual Report 2013, RWE.6. Annual Report 2013, Verbund.


Supply: one of the main stories in 2013

Alongside depressed power prices, adverse supply conditions for conventional power generation are another key element that explains why impairment numbers reached historic highs in 2013. In the context of stagnating demand in many parts of Europe, the rapid rise of renewables, which typically benefi t 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 onlarge-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 millionas the situation worsened: imports of liquefi ed 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 signifi cant proportion of traditional thermal power generation will increasingly be used to cover peak demand, which does not enable them to earn a suffi cient return compared to their investment costs overall.

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.

7. 2013 fi nancial report, Iberdrola.

Figure 2. Wholesale power prices fell during 2013 across much of Continental Europe, and saw little sign of improvement in H1 2014

Sources: EY analysis; Bloomberg.

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

20

30

40

50

60

70

80

Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14

European power prices (one-year forward baseload)

Germany SpainNordicsItaly UK

€/MWh


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 2014–35. The vision expressed by the Group in this scenario results in thermal power plants which will be increasingly used to fi ll 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 qualifi ed 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 astand-alone driver

In 2012, demand did not appear to be the primary justifi cation for impairments reported by our 16 sample companies; it was chiefl y 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 fl at.”

The evolution of demand could well become one of the key factors to affect utility profi tability 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 2035.9 In response, utilities are looking to create new revenue sources by becoming energy services providers.

Policy: local impacts only in 2013

National policy clearly did not have sector-wide impact in terms of impairment in 2013. However, the magnitude of regulatory impacts in certain localized areas or specifi c 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 fi scal year, impairments were recognized on property, plant and equipment in the amount of €1.373 million. The most signifi cant 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 refl ects, largely to the same extent as the other parameters used in the determination, the expected contraction in estimated future cash fl ow 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.”

Policy alone did not result in anysector-wide impairment — but regulatory change in Russia and the US caused sizeable impairments for selected European utilities.

8. CEOs of leading European energy companies contribution to the European council,20–21 March 2014, https://www.gdfsuez.com/wp-content/uploads/2014/03/recommendation-for-the-european-council-from-ceos.pdf, 19 March 2014.

9. EU Energy, Transport, and GHG Emissions, Trends to 2050, Reference Scenario 2013, The European Commission, 16 December 2013.

Sluggish economic growth and improved energy effi ciency may continue to dampen demand until 2035: this could be a key driver of future impairments.

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 fi nancial 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 2013Financing conditions do not appear to have been a big story in 2013. Centrica is the only company in our sample to mention a change in the discount rate as an underlying reason for impairing specifi c assets for a limited amount: “We recognized a post-tax impairment of £66 million on our existing gas assets in Canada, refl ecting 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 2012.

Table 5. Selected examples show no major changes in the discount rates between 2012 and 2013

A substantial amount of goodwill remains on utility balance sheetsDespite 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 specifi c fi xed assets, in the future.

Table 6. Goodwill on utility balance sheet in 2013 accounts

Source: 2013 company annual reports.

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

Pre-tax real rates used in 2013 range from 7% to 10% (unchanged from 2012).

Veolia Rates used in 2013 range from 6.4% to 7.4% (range of 6.0% to 7.7% in 2012).

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 £ 636 763

Verbund € 742 742

CEZ CZK 9,607 350

Fortum € 275 275

Total — — €100,918



Looking forward3


The environment in which European utilities are operating does not appear to have seen any immediate improvements so far in 2014. Two recent examples demonstrate the challenges they continue to face in the current year:

• May 2014 saw reports of a bailout of the 335MW gas-fi red Elcogas plant near Puertollano in Spain.10 The three shareholders (Endesa, EDF and Iberdrola) had to provide fi nancial support as a €127m debt fell due, and as a result, Endesa made a €51m provision in its results for Q1 2014.

• In the same month, the UK’s Centrica announced that it planned to sell its three largest gas-fi red power stations (Langage, Humber and Killingholme), with a combined capacity of 2.7GW in order to focus its UK gas-fi red generation strategy on smaller fl exible “peaking” plants.11

When assessing the risks that Europe’s utilities face today, we believe fi ve factors will have a particular infl uence 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 mechanisms4. Ongoing evolution of the EU Emissions Trading Scheme

(EU ETS)5. LNG exports from the US

Utilities can only directly control the fi rst 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 capacityIn 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 signifi cant (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 2013.14

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

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 signifi cantly:

• 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 2012.

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 2014.12. For detailed analysis of the renewables sector, please refer to EY’s latest Renewable energy country attractiveness index available at http://www.ey.com/UK/en/Industries/Cleantech/Renewable-Energy-Country-Attractiveness-Index.

13. “Wind in power – 2013 European statistics,” European Wind Energy Association,February 2014.14. “Market Report 2013,” European Photovoltaic Industry Association, March 2014.

Wind Solar PV

Installed base Net additions

20132012 201320120

20

40

60

80

100

120

140

GW


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 968 Oil 742 Coal

converted to biomass

1,410 Gas

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 Fenosa

157 Oil —

EDP 946 Oil —

Total 9,650 6,543

As we previously outlined, 2012 saw the major generators facing up to this dilemma and accelerating the process of closing or mothballing signifi cant tranches of unprofi table 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-fi red capacity out of operation, as shown in Table 7.

Table 7. Closure/mothballing of thermal capacity in 2013 by European utilities in our sample

Sources: Company reports; EY analysis.

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 profi tability 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 profi t 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 fi rst.

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.


In 2013, across Europe, 10.1GW of gas-fi red capacity, 7.7GW of coal-fi red capacity and 2.8GW of oil-fi red capacity were decommissioned.15 Upcoming signifi cant 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-fi red capacity means that overall, net capacity was actually added to the system in 2013.

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.

Although utilities have been removing signifi cant 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.

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-fi red plant is expected to come online by 2016. Most of this relates to “legacy” projects planned back in 2008–09. 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.

In fact, it is quite possible that we could start seeing further asset impairments — but this time of coal-fi red plants. Any new coal-fi red capacity, be it anthracite or lignite plant, is likely to start squeezing older, less effi cient coal-fi red plants out of the merit order, drastically reducing running hours and profi tability. At the same time, all coal-fi red 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 mechanismsThe scale of closures and mothballing of thermal capacity — and more fl exible gas-fi red 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 fi rm 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 specifi cs 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 2014.

Sources: European Photovoltaic Industry Association; EY analysis.

Figure 4. Net power generation capacity changes in Europe in 2013

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Figure 5. Existing/proposed capacity remuneration mechanisms around Europe

CRM operational/decision taken to implement

CRM proposed/under construction

No CRM (energy-only 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 suffi cient to ensure that the fl exible thermal capacity needed to back up intermittent renewables remains on the system. With gas-fi red plants increasingly moving from baseload generation to a more fl exible role, lower utilization levels are no longer suffi cient to cover fi xed costs (or in some cases, running costs). CRMs are seen as necessary means of plugging that gap and enabling fl exible thermal capacity (typically gas-fi red) to continue in operation, but with fewer operating hours.

“Marginal pricing is not the solution to a system that is driven by fi xed 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 fi rm capacity].”

Ongoing evolution of the EU ETSThe price signals for carbon generated by the EU ETS potentially could have a signifi cant impact on power markets across Europe.

This “cap and trade” scheme was fi rst introduced in 2005. Since then utilities have become familiar with the general principles of its operation. However, 2013 saw a number of signifi cant changes. First, from 2013 onward, the cap on emissions from power stations and other fi xed 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.

16. “Energy-only no longer fi t for purpose,” Power in Europe, Issue 676, 12 May 2014, Platts, via McGraw-Hill.

Sources: EY analysis; Thomson Financial Datastream.

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 fi nancial 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

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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.

Proposals to reform the EU ETS offer the prospect of higher carbon prices in the future, which would benefi t gas-fi red plant at the expense of more carbon-intensive forms of generation. This is unlikely to have a signifi cant 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.


As a short-term measure, the EC has postponed the auction of 900 million carbon allowances until 2019–20 (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 signifi cant fi nancial advantage to gas-fi red plant at the expense of rival coal-fi red capacity.

LNG exports from the USThis 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 signifi cant 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-fi red and coal-fi red power margins. In the UK, this offers some prospect of the more effi cient gas-fi red 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 profi tability of utilities in the medium term. It will be the end of the decade at least before export volumes reach suffi cient scale to have a signifi cant 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.20

17. For a useful summary, see “EC wants 40% carbon reduction for 2030 and scrutiny to boost renewables,” New Power Issue 60, Publishing Energy, February 2014.18. “Iberdrola agrees to LNG supply deal with Cheniere over 20 years valued at around€4.1 billion,” Iberdrola, 30 May 2014.

19. “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.

Benchmarking European power and utility asset impairmentsBenchmarking European power and utility asset Impairments

ConclusionFacing up to a new economic paradigm for utilities in EuropeWith a €32b cleanup from company balance sheets, 2013 has been particularly diffi cult 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 fi ve key factors discussed in Section 3. We believe that these factors will have a major role to play in shaping the profi tability of utilities in Europe over the next 5 to 10 years, and we expect to see businesses reorganized and strategies redefi ned. 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 profi tability of thermal generation?

• What will be the energy mix of the future, and how will energy effi ciency efforts and new electricity usage shape the future of electricity and gas demand?

• Will the global trend toward more stringent CO2 emission regulation profoundly change CO2 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-fi red 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 environmentHowever, 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 confi dence. Given the huge scale of investment needed to renew and expand infrastructure, investor confi dence is one asset that will be key to utilities as they navigate through a sector in transformation.

Benchmarking European power and utility asset impairments 19

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About EY’s Global Power & Utilities CenterIn 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.

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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.

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Contacts

AuthorsGuillaume CatoireAssurance Power & Utilities Sector Resident, EYTel: + 33 1 4693 4616Email: [email protected]

Duncan ConeybeareSector Analyst — Power & Utilities, Global Markets — EY Knowledge Tel: + 44 20 7951 5628 Email: [email protected]

ContributorCharles-Emmanuel ChossonGlobal Assurance Power & Utilities Leader, EYTel: + 33 1 4693 7162Email: [email protected]

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