From nirvana to disaster

European utilities were once a darling of investors. From 2000 to 2010, utilities outperformed the market (Stoxx 600) by over 60% as investors gravitated towards the power sector for stability and income. The following decade was one of startling decline: from 2010 to 2016, the Stoxx 600 increased 40% while utilities lost around 20% of their value, as over investment coupled with a failure to understand policy, technology and business model changes impacted performance. As investors fled and rating agencies issued downgrades, utilities responded by acknowledging mistakes and restructuring their businesses.

Mistakes made, lessons unlearned

“I grant we have made mistakes. We were late entering into the renewables market – possibly too late.” RWE’s CEO, Peter Terium, 2014

Despite experiencing first-hand the financial consequences of ignoring the transition to a low carbon economy, several utilities appear to believe coal-fired generation will play an important role in the EU power mix for the foreseeable future. Based on company reports and including member state phase-out policies, only 27% of operating coal units in the EU are planning to close before 2030. We believe this view is based on a series of outdated and misguided assumptions about the economic viability of coal, the competitiveness of alternatives and security of supply concerns.

Lignite of the living dead

Confidence in coal-heavy utilities is returning as business restructurings, court rulings and power prices have revived balance sheets after years of huge impairments. For example, at the time of writing, RWE and Uniper have seen their share price increase by 64% and 79% respectively in 2017. However, we find that falling renewable energy costs, air pollution regulations and rising carbon prices will continue to undermine the economics of coal power in the EU, potentially making generation assets unusable by 2030.

Specifically, this report finds:

• 54% of coal is cashflow negative today increasing to 97% by 2030 – making units reliant on lobbying to secure capacity market payments (which the European Commission wants to prohibit by 2025) and avoid air pollution regulations.
• The operating cost of coal could be higher than the LCOE of onshore wind by 2024 and solar PV by 2027, while battery storage and demand response increasingly provide auxiliary services and peak shaving.
• Since the majority of coal units are lossmaking by 2030, the EU could avoid €22bn in losses by phasing out coal power in line with the Paris Agreement.

Below 2°C scenario analysis – the EU could avoid €22bn in losses by phasing out coal in line with the Paris Agreement

Our net present value (NPV) model seeks to replicate the real-world economic and investment decisions associated with a phase-out of coal-fired power in the EU. The model values every operating unit in the B2DS and a business as usual (BAU) scenario to understand stranded value. Stranded value is defined as the difference between the NPV of cashflow in the B2DS (which phases-out all coal power by 2030) and the NPV of cashflow in the BAU scenario (which is based on retirements announced in company reports). Both the B2DS and the BAU scenario acknowledge existing phase-out policies by member states. As most of the coal units are loss-making out to 2030, the total stranded value in the B2DS is negative – meaning the EU could avoid €22bn in losses by phasing out coal power in line with the Paris Agreement. The utilities who have the most to gain from phasing-out coal by 2030 are RWE and Uniper who could avoid losing €5.3bn and €1.7bn, respectively. CE Oltenia SA and Enel are the only utilities surveyed in this report which stand to lose (€170 and €34m respectively) from retiring their coal units in a manner consistent with Paris.

The coal units operating in Germany could avoid losing €12bn by retiring early, while units in Poland could avoid losing €2.7bn. The UK has proportionally lower nagative stranded value due to the fact it already has a phase-out policy. By phasing-out coal the UK is not only acting in the best interests of their citizens through improved air quality, but also the financial interests of utility shareholders through avoided value destruction. Italy and Slovenia have positive stranded value of €480m and €740m, respectively. To a much lesser degree, Portugal, Romania, Ireland and France also have positive stranded value and could lose a trivial amount if the EU complies with Paris.

Recommendations for investors and utilities

Utilities with exposure to coal power in the EU are at a strategic crossroads: continue to invest in coal and hope governments will allow rent-seeking in the form of capacity and retirement payments, or divest and prepare for a low carbon future.

The recent announcement of more stringent air pollution limits and reforms to the EU emissions trading system highlight the risk in a pro-coal strategy. Moreover, low cost renewable energy, battery storage and demand response are energy sector mega trends which will change power systems in Europe and throughout the world. Those utilities that expect to run their coal units longer than evidence suggests are putting their assets on a collision course with these mega trends.

Investors should adjust the valuation ascribed to coal generation assets held by utilities. This will involve using an asset-level model which provides a 2030 retirement schedule by dynamically determining which units close when.

Utilities should acknowledge and prepare for coal to be phased-out by 2030 due to combination of policy commitments, technological progress and business model changes. Moreover, utilities should prepare for the reality that compensation may not get paid for early closure. The Netherlands’ phase-out is a case in point: by incorporating a carbon price, the government has avoided paying compensation to asset owners