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IEEFA Europe: Poland’s PGE would do well to accelerate plans to diversify away from coal

Rising risk in adhering to a traditional power generation business model

LONDON — Poland’s biggest utility, PGE, should accelerate its plans to diversify away from coal, as surging carbon prices underscore risks gathering around its present PLN 21 billion ($5.6 billion) coal power investment programme.

To date, PGE has deferred such plans, avoiding, for example, moving into offshore wind until the mid- to late-2020s, and only after its current massive investment initiative has cemented the utility’s dependence on coal.

In mid-June, the Institute for Energy Economics and Financial Analysis (IEEFA) highlighted two key risks around these coal power investments, both of which are beyond PGE’s control: rising European carbon prices and dependence on Poland’s new capacity market.

Since the publication of that report, European carbon prices have risen by one third, to €20 per tonne of emissions (a more than doubling this year to date). These rising carbon prices will seriously threaten returns on PGE’s coal investment programme, which includes: last year’s PLN 4.3 billion acquisition of EDF’s Polish coal assets; PLN 1.9 billion worth of upgrades of existing assets, to comply with new EU pollution standards; and PLN 15 billion investment in three new units at Turow and Opole.

Poland is one of Europe’s most coal-dependent economies, and inevitably the government is sympathetic to the future of mining communities and the attractions of an indigenous energy resource. But we note that PGE is even more coal-intensive than the country at large, where coal and lignite accounted for less than 80% of generation last year (PGE: 91%); and wind for 9% (PGE: 2%).

In total last year, PGE invested some PLN 81 million in renewables (wind, solar, hydro), compared with PLN 4,899 million in conventional generation (coal, gas and biomass).

Referencing these findings, and the IEEFA report, shareholders asked PGE a series of questions about PGE’s carbon exposure, at the company’s annual general meeting in July.

Two answers offered up by the company seem especially relevant.

Investors seem not to be buying a purported success story.

First, the company seemed to misunderstand the size of its carbon exposure. When asked how coal divestment campaigns may impact PGE, the company stated that its “ongoing investments have a positive impact on reducing CO2 emissions.” Obviously, this cannot be the case, because PGE has just acquired a fleet of coal power plants from EDF, which can only increase carbon emissions.

In 2017, PGE’s carbon emissions rose 6.3% compared with the year before, and carbon emissions per unit of power generation (called carbon intensity) rose by 0.5%. PGE’s first-half results are worse, reflecting further consolidation of its recent acquisition. Carbon emissions in the first half of 2018 were up 21.1% compared with the corresponding period last year, and carbon intensity up 2.5%. Clearly PGE’s investments have not had “a positive impact on reducing CO2 emissions”.

Second, PGE was vague in how it spoke about the impact of rising carbon prices on investment returns. The company said that it expected to make returns on its PLN 1.9 billion coal power upgrade programme that exceeded the company’s cost of capital of 7.29%. When asked what impact a €10-higher carbon price would have on those returns, company officials stated merely that this depended on local, site-specific factors, as well as electricity prices.

The latter is undoubtedly correct, but PGE will already know its vulnerability to a rise in carbon prices, all else being equal, and investors will want to know the same, especially given new forecasts that carbon prices could rise by another 50% (or €10) by 2021.

To date, investors seem not to be buying the PGE story: over the past 12 months, shares in PGE have fallen 37% (since Sept. 5, 2017), while the Warsaw Stock Exchange Total Return Index (WIG) is down 7%.

Figure 1. Relative 1-year performance of PGE and the Warsaw Stock Exchange

PGE and the Warsaw Stock Exchange

Source: MarketWatch

THOSE DECLINES IN PGE SHARE PRICE HAVE COME DESPITE AN EXTRAORDINARY INCREASE IN WHOLESALE POWER PRICES over the year to date, and especially in the past few months.

Polish 2019 contracts for baseload power have risen by 24% since mid-June, or by €11.4/ MWh, compared with about €4.4/ MWh in higher carbon costs for the average coal power plant, and €0.8 higher coal fuel costs (given various assumptions about coal calorific value and power plant efficiency).

In other words, power price rises have out-stripped similar rises in coal and carbon prices, and gross margins may actually have risen, as a result.

But these power price rises are not sustainable. We note that the Polish energy regulator is presently investigating why they have risen so fast, while the energy ministry has made sweeping changes to electricity trading, requiring all power trade to be made across exchanges in future, to prevent further “unjustified growth.”

We conclude that higher carbon prices are all but inevitable, while the same cannot be said for Polish power prices. The result would be squeezed profits.

Regarding PGE’s coal power upgrade programme, IEEFA has previously calculated that PGE was the single most impacted utility in Europe from new EU pollution controls known as “Revised BREF.”

Already, PGE has invested hundreds of millions of euros in BREF compliance upgrades, and it is planning sinking hundreds of millions more. We estimate that last year alone, PGE invested more than PLN 300 million in such upgrades. As carbon prices rise, any prospect that PGE will make an attractive return on these investments diminishes.

PGE is already planning some diversification of its energy mix over the next decade. By radically expanding and expediting that strategy, in part by cancelling some coal power upgrades, and accelerating investment into alternatives, it can reduce its exposure to rising carbon prices.

In its answers to shareholders in July, PGE left the door open to closures instead of BREF upgrades, at some coal units, stating that: “In the case of several locations, analysis is still ongoing and final decisions have not been made yet.”

PGE would do well to grab the chance to cancel further BREF investments in favour of more growth-oriented strategies that it has already started to identify in generation and services, for example in renewables, smart homes and electromobility.

Gerard Wynn is a London-based IEEFA energy finance consultant. He can be reached at gwynn@ieefa.org. Paolo Coghe is an energy economist based in Paris.

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