Commentary

Czech investors and Vattenfall coal

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Bucket excavator air

The envisaged sale of Vattenfall’s East German lignite assets to EPH has raised many questions about the sustainability of open-cast lignite mining and power generation. It has also shone a spotlight on the prospective new owner. EPH is a fast-growing privately owned utility based in the Czech Republic with a risky business model that might end up costing the German taxpayer dearly.

As a vertically integrated energy company, EPH’s portfolio contains power and heat generation, electricity and gas sales, trading and distribution, as well as lignite mining assets. EPH owns the Eustream gas transmission grid, which carries natural gas from Russia to Europe via Ukraine, as well as gas storage facilities in Slovakia. The company is buying up fossil fuel assets across Europe, in particular lignite and gas, and owns or co-owns assets in the Czech Republic, Germany, Slovakia, Italy and the UK. Due to its risky business model and high leverage ratio, EPH is exposed to a range of serious regulatory and market risks.

The Slovak gas transmission company Eustream is the single most important contributor to EPH’s EBITDA, accounting for 32% (based 2014 figures). Moreover, 78% of EPH’s power generation assets are gas-fired. EPH therefore has significant exposure to volatility risks in gas supplies and gas markets, especially at a time of decreasing gas consumption in the EU. EPH’s focus on gas transmission from Russia to Europe via Ukraine exacerbates this risk.

The acquisition of Vattenfall’s lignite assets in Germany would expand EPH’s lignite portfolio from 2,812 MW to 10,365 MW. Accordingly, the share of lignite capacity in its portfolio would increase from 40% to 72%. This would expose EPH to significant regulatory risks, as European and German climate policies are very likely to become stricter over time.

Germany is set to phase out lignite within the next two decades. This is not only due to domestic climate targets; there are also increasing challenges to the profitability of lignite. Discussions are already underway concerning the policy instruments that would be required for a future phase-out, including compensation for workers and the affected regions. The withdrawal of 2.7 GW of lignite capacity from the market through the formation of a capacity reserve, as was agreed last year, constitutes only a first step. The measure will cost the taxpayer around €1.6bn by 2023, when the power stations in the reserve will be retired for good. The benefit for Vattenfall’s assets will be approximately €600m.

EPH’s possible motivation for increasing its exposure to lignite and carbon price risks thus becomes clear. Based on Candole Partners market modelling of the EPH portfolio, it makes little to no commercial sense to acquire these assets. The company’s most likely incentive would therefore be the prospect of a future capacity market in Germany from which the utility RWE and Vattenfall’s successor would likely benefit disproportionately. EPH might also be betting on the failure of the Energiewende and the EU’s climate policy, including the ETS which currently suffers from a very low carbon price.

There may, however, be short-term value in acquiring Vattenfall’s assets. Vattenfall has committed to transferring a sum of €1.7bn to EPH for legally required mine reclamation costs. Moreover, the fleet will still be generating operating cash flow for a number of years, at least as long as the carbon price stays low. EPH could use this cash flow either for further investment, for deleveraging the company, or for paying out dividends to its shareholders once the moratorium on dividends – as stipulated in the contract with Vattenfall – expires after 3 years. But this short-term calculation likely only makes sense if the company has plans to avoid or cut the follow-up costs of mining.

In addition to the risks for EPH itself, there is also significant risk for the German taxpayer. A sale to a partner with high leverage (a debt-to-equity ratio of over three is relatively high compared, for example, to 2.86 in the case of Vattenfall or 1.36 in the case of CEZ) and an unclear long-term strategy for the acquired assets, including their ultimate closure and the reclamation of the land, creates enormous liability risks. The costs for the transition process out of lignite may have to be socialised if the acquiring company defaults on its obligations. The German taxpayer will therefore be underwriting the transaction and taking on the ultimate liability should the buyer’s gamble fail.

In conclusion, the acquisition of Vattenfall’s German lignite assets likely means that EPH may by speculating on the introduction of capacity markets or on the failure of the ETS, EU climate policy and the German Energiewende. Given EPH’s high debt level and significant exposure to commodity risks, it is entirely plausible that the liabilities of mine closures and reclamation measures will end up with the taxpayer. 

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