PGE is Poland’s biggest energy company. The company is majority state-owned. Despite significant talk of a renewables revolution, the company’s electricity generation mix remains overwhelmingly biased towards coal and lignite, which accounted for a combined 86% of its total generation in the first half of 2020. Wind and solar power accounted for less than 3%.
In October, PGE announced its longawaited strategy for 2030. However, regarding renewables, PGE’s new strategy looks rather similar to its previous direction, as set out in its latest “PGE in Transition” document in January 2020. PGE’s most significant renewables target, for offshore wind, was left unchanged. The company upgraded its solar and onshore wind targets. But we calculate that the new 2030 targets for solar PV and onshore wind still trail the country’s national targets under the National Energy and Climate Plan (NECP) published last year.
Under the new strategy, PGE does set out ambitious plans to spin out its entire coal and lignite portfolio. But these plans are at present officially undated, unfunded and with no agreed mechanism. Critically, the new strategy has no new targets for actual, individual coal power plant retirements.
For more than two years, IEEFA has repeatedly stated that PGE is facing a strategic choice that will determine its financial stability. Through a series of reports, we have shown how the introduction of coal power subsidies via a new capacity market in Poland is unlikely to offset the impact of rising carbon prices on coal profits. We have shown how PGE’s capital expenditures have become more focused on coal, risking shrinking cash flows on a rising debt load. Higher carbon prices pose a particular short-term risk. Access to capital is also emerging as a short- to medium-term threat. Financial regulators and investors now accept that the financial sector must play a significant role in driving a low-carbon transition.
PGE’s longer term revenues are uncertain because the utility is exposed to a variety of risks it cannot control. These uncertainties exist over different periods of time, are driven by fundamentally different sources of risk, and build upon each other. For example, the European Union is constantly modifying energy policy to favour renewables, while the cost of renewables is also falling; these two trends are independent of each other, and as such, add up. Many of these risks would not exist or would be largely mitigated if PGE elected to close some of its most polluting units and divert freed-up capital to EBITDA-positive renewables.
Method and Findings
In this report, we show how the performance of PGE’s coal and lignite assets has underperformed expectations, as a result of a coronavirus pandemic that has exposed PGE’s lack of diversification in electricity generation.
Regarding the coronavirus pandemic, we focus on three key market impacts relevant to PGE. First, an economic lockdown has reduced power demand, leading to lower power prices. We find that wholesale power prices have fallen as much as 14% across the forward curve from 2021-23. Second, the pandemic triggered a flight to low-risk assets, including low-risk currencies such as the euro. We find that the Polish zloty (PLN) has depreciated by 5% against the euro, while gaining 3% against the dollar. This forex change has combined with the third impact, on commodity prices. The economic lockdown has reduced demand for certain commodities, leading to lower coal and natural gas prices and exacerbating current trends in lower fossil fuel prices. Meanwhile, carbon emissions prices (EUAs) have risen slightly, as a regulated market with a supply-demand dynamic somewhat insulated from energy markets. After taking account of forex moves, the PLN denominated price for EUAs has risen strongly, by 15% on average across the traded forward curve.
We use commodity and power prices in forward markets from 2021-23, and thereafter assume these rise by inflation (2.5%). Regarding foreign exchange prices, we assume these are unchanged, applying today’s spot price through 2030. We apply changes to these prices to our calculation of PGE earnings before interest, taxes, depreciation, and amortisation (EBITDA). In calculating EBITDA, we focus solely on PGE’s generation business, i.e., excluding electricity distribution and supply. We apply fixed capacity factors based on data from Poland’s National Energy and Climate Plan. This is a largely static model: We do not account for hourly despatch or seasonality. We assumed installed fossil fuel and renewables capacities according to two core scenarios, before and after the publication of PGE’s “Strategy 2030.” We also introduced a high- and low-carbon price scenario, the latter based on the present forward market (c. €28 in 2024), and the former raising carbon prices to €35 in 2024 and €40 in 2030. We do not account for any corresponding power price inflation as a result of these higher carbon prices.
We note that by locking in today’s forex prices to 2030, and escalating the forward curves rather than forecasting prices, we are penalising PGE, not least given the volatility of forex and commodity prices that could move back in PGE’s favour. However, we justify this penalty to highlight PGE’s own failure to diversify its energy mix. This failure has made the company vulnerable to margin squeezes in the short to medium term, caused by factors outside its control, including moves in commodity and forex prices. Over the long term, unmitigated large exposures to variables such as adverse policy changes or technological advances in renewable energy sources (RES) could cause capital destruction and lead to stranded assets.
Our two core scenarios are before and after COVID, with PGE’s previous and new energy strategies, respectively. We call these two scenarios EBITDA Feb 2020 and EBITDA Nov 2020. We find PGE’s EBITDA is severely affected by commodity price changes. PGE’s “Strategy 2030” is inadequate to offset this negative effect.
First, we compare PGE’s all-generation EBITDA before and after the new strategy and COVID. Figure below shows that EBITDA falls by about half through the next decade, in the EBITDA Nov 2020 scenario, a shocking impact.
Drilling into our updated EBITDA projections, we separate PGE’s coal and lignite from the rest of the business, i.e., renewables, CHP and gas. We show that the combined coal and lignite business loses money after 2026, an astonishing finding given that this accounts for 86% of PGE’s electricity generation today. The EBITDA of the rest of PGE’s business rises to PLN5.9 billion in 2030, but still lags our projected pre-COVID EBITDA of the combined business (PLN8.2 billion). Our main takeaway from Figure 3 is that PGE must radically accelerate both its renewables capacity additions and its coal power retirement.
Finally, we investigate the impact of a higher carbon price, rising to €35 in 2024 and €40 in 2030. We note that this “high-carbon price” scenario in fact is only 23% more than the base scenario and is entirely plausible, given that the European Commission in September announced plans to tighten its emissions reduction target in 2030. The plans call for a 55% reduction versus 1990 levels, compared to a previously planned 40% reduction. Under our high-carbon price scenario, PGE’s generation business suffers even more, falling more than half when compared with our base-carbon price post-COVID scenario, to PLN2 billion from PLN4.7 billion.
PGE’s EBITDA is so deeply affected by high carbon prices because of its coal and lignite generation. We note that PGE has announced under its “Strategy 2030” plans for new combined cycle gas turbines (CCGT) and coal to gas CHP conversions. Although gas is less carbon-emitting than coal, it still faces carbon costs. In addition, the use of gas is coming under growing policy pressure. Financing or investing in combustion-based forms of generation today will have a potentially huge price tag if the transition to a cleaner, fossil-free EU is completed before such generation has fully depreciated. That transition is already in progress and jeopardizes future cash flows from gas generation. Supporting this view, the EU’s 2050 net-zero goal indicates that fossil fuels will be phased out quickly enough to strand gas assets being built today.
PGE’s current energy investment options are in a sense zero-sum, between fossil fuel and renewables—more of one means less of the other. In this context, and given the higher risks and uncertainties associated with fossil fuels, it is preferable for PGE to invest urgently today in profitable, cash-generating renewable power capacity and shift decisively from a legacy of under-performing assets.
The story has been sourced from IEEFA and can be accessed by clicking here