Decision time at Poland's PGE: Why a high-risk, fossil-heavy strategy doesn't add up

PGE, Poland's largest utility, is facing a strategic choice that will determine the company's financial stability in the years ahead: stick with its current fossil fuel-heavy generation profile or begin transitioning to a renewable energy-based portfolio to start to address rising environmental and market risks.

The issue forcing this decision is the European Union's new round of air pollution emissions standards that take effect in 2021. These new, stricter standards—agreed to by EU member states last year and listed in a Best Available Techniques Reference Document (BREF)—will hit PGE hard. First, they require environmental upgrades whose cost will undermine the competitiveness of the associated power plants. Second, PGE will hope to use payments under Poland's new capacity market to fund the upgrades, but may find itself less able to secure these, given higher costs as a result of BREF and rising carbon prices. Critically, capacity payments and carbon prices are risks largely or wholly outside PGE's control.

PGE is majority-owned by the Polish government. It is overwhelmingly dependent on coal and lignite for its electricity generation. The company's hard coal and lignite plants accounted for 91% of total generation in 2017, compared with 4% from renewables, with the balance supplied by gas and biomass. The company's bias toward coal increased last year with its acquisition of the Polish assets as part of a strategic divestment by French utility EDF. As a result, PGE is one of Europe's biggest polluters and will be one of the European utilities most affected by the new emissions standards.

Company data for PGE's emissions of nitrogen oxides, sulphur oxides and dust for 2016 and/or 2017 show that just four out of 15 of the utility's smokestacks met the 2021 BREF standards for all three pollutants. In other words, PGE has a choice: it can move to close the non-compliant units and turn to cleaner alternatives, or it can invest to upgrade their environmental performance.

PGE's decision thus far has been to double down on its coal facilities, launching a major programme to upgrade its non-compliant units. In its 2017 annual report, the company said it plans to invest a further PLN 1.9 billion (€475 million) to meet the 2021 standards. In recent announcements PGE has stressed its desire to go green, but we find evidence to the contrary: In 2017, capital expenditures in renewable energy fell 44% to just 1% of the group's total.

This report demonstrates that PGE's coal-heavy approach is misguided and will end up costing the utility much more than pursuing a strategy based on building new renewable energy generation.

To reach that conclusion, we use published BREF capital expenditure data at two of PGE's power plants, and our own estimates for additional costs, to calculate the impact of the new emissions standards on the levelised cost of electricity (LCOE) generation. We estimate BREF compliance would raise generation costs by 15% to roughly €40/MWh for a sample lignite power plant, and by 10% to €50/MWh for a coal-fired combined heat and power (CHP) plant.

For purposes of illustration, we compare these findings for coal and lignite BREF upgrades with LCOE estimates for the cost of electricity generation from new onshore and offshore wind farms and new solar power in Poland. We estimate the cost of onshore wind at €39/MWh, offshore wind at €62/MWh and solar power at €82/MWh. We conclude that ongoing deflation in renewables costs makes them broadly competitive with coal and lignite, while avoiding fuel, power and carbon price risk, and avoiding future cycles of tougher pollution controls.

We identify two key risks associated with PGE's BREF coal power upgrade investments: steeply rising carbon prices in the EU, and an emerging reliance on capacity payments under Poland's new capacity market.

Regarding carbon price risk, we note that EU allowance (EUA) prices have more than trebled over the past year, to €16 at the end of May, and analysts forecast rising prices through 2030. Higher carbon prices pose a particular financial risk for PGE because of its extraordinary reliance on high carbon-emitting coal and lignite. The company's allocation of free EUAs has steadily fallen over the past decade, following market rules, meaning it now has to pay for most carbon dioxide emitted. Resulting higher costs for coal and lignite power plants could mean they run less frequently and less profitably.

Regarding capacity market risk, Poland introduced a capacity market this year modelled on Britain's competitive auction model. PGE will hope that capacity payments cover the capex costs of its BREF upgrades and coal new-build programmes. However, we note that new technologies and interconnections have already disrupted capacity payment-based strategies in Britain, driving record low capacity market prices and forcing older coal units to retire. Such an outcome is a real danger for PGE.

We note other, wider risks to PGE's planned BREF upgrades. These include: low generation diversity which may impair its ability to refinance rising levels of net debt; expected growth in renewables both domestically and via imports which may have a deflationary impact on wholesale power prices and coal running times; EU-backed national investment in demandside controls which poses down-side risk to PGE's demand projections; and other risks, for example to secure expanded mining concessions, rising mine rehabilitation costs and political risk from environmental activism.

We combine our estimated BREF compliance costs and two key carbon and capacity market risks in a "Hurry versus Wait" analysis, which compares two scenarios in a stylised thought experiment. The Hurry option involves an overnight shift to 100% renewables. The Wait approach maintains PGE's existing energy mix, at 96% coal and gas. The highrenewables scenario is €4 billion more expensive, on a present value basis, before we account for carbon costs and capacity payments. For the high-fossil fuel Wait scenario, even a generous assumption of €5 billion of capacity payments fails to offset €12 billion carbon costs under a €15 carbon price. The overall net result is that the Wait scenario is €3 billion more costly.

This analysis illustrates mutually reinforcing risks to PGE's fossil-heavy strategy. Environmental upgrades to comply with BREF, rising carbon prices and growth in renewables will all reduce the competitiveness of PGE's coal fleet, making it more difficult to compete in capacity auctions. PGE's reliance on future capacity payments therefore constitutes a large, unmitigated risk which is beyond their control. We conclude that PGE should transition to a majority renewables portfolio over the medium term and start that transition by diverting some of its planned air emissions upgrade expenditures to a green growth strategy. The benefits of accelerating a low-carbon transition at PGE include reduced carbon costs and neutralization of climate and pollution regulatory risks.

Given our findings, we offer these questions for PGE's independent shareholders and lenders to consider:

1. Has PGE's strategy to comply with BREF, and to build new coal and lignite power plants, left the company with too little capital and strategic room for manoeuvre? PGE is presently marching in the opposite direction of a low-carbon transition, and as a result most of its European utility peers.
2. Which coal and lignite power plants and CHP units will PGE close, as a result of BREF? PGE has not yet publicly responded to BREF with any closure plans. Its fleet includes old, non-compliant units where new environmental upgrades have not yet started, which are natural targets for closure, including certain units at the newly acquired Rybnik power plant.
3. How independent is PGE from its majority shareholder, the Polish government? PGE's current coal-heavy plan appears closely aligned with the government's policies. Undue strategic influence by the Polish government poses a corporate governance risk for independent shareholders given the lack of alignment with broader EU policies.
4. What are PGE's real plans after 2020? The company's "go-green" talk is decidedly light on specifics, for example including a long wish-list of possible interests, but entirely opposite to the actual actions of management over the last year.
5. Does it make sense to identify a "significant easing of climate policy" as one of three key strategic options, as PGE management is doing? Given PGE's large carbon exposure, to us it would be wiser to prepare for a much more aggressive tilting of climate policy, for example by committing to a firm target year for full decarbonisation.

Press release: IEEFA Europe: PGE’s pro-coal strategy in Poland under fire

Please view full report PDF for references and sources.