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Rising Risks for Europe's Power Utilities

Bigger investment needs, conflicting objectives, and supply-security concerns are making for an uncertain future

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From Standard & Poor's RatingsDirect
Generators and vertically integrated utilities in Europe's liberalized markets are enjoying high profits resulting from continuing strong power prices, which reflect high oil and gas prices and the introduction of the carbon-dioxide (CO2) emissions trading scheme (EU ETS). In fully liberalized European power markets, where electricity pricing is based on marginal generation costs and where gas-fired generation technology is the price-setting generation technology (as in Britain), the high gas prices can largely be passed along as higher retail power prices.

Meanwhile, margins are boosted for non-gas generation such as nuclear and hydro power, which don't bear higher commodity input or CO2 costs. Other factors also underpin cash flow generation and profits: The sector is fairly concentrated, and competitive behavior appears more focused toward margin protection rather than market-share maximization.

KEY ISSUES.  Meanwhile, end-customer market power remains limited. Assuming a stable regulatory environment, no evident factors suggest any fundamental change to this situation for the foreseeable future.

A number of issues on the horizon, however, need to be monitored, as they're leading to some uncertainty over future developments in Europe's power industry. The following trends in particular could pose challenges that imply a higher business risk for the European power sector:

• The introduction of CO2 trading and continued high oil and gas prices has increased the volatility of European power prices, and uncertainty exists over the development of fuel prices. Market risk among European utilities could increase in the medium to long term as a result of high energy prices and the accelerating globalization of industries.

• The financial success of utilities is controversial, and increases longer-term political and regulatory risk. This comes against the backdrop of concerns over the competitiveness of European industries.

• Investment needs are increasing as demand continues to grow and European utilities are facing the first investment phase in a deregulated environment, incurring significantly higher risks than in previous periods when regulatory protection was offered.

• The arguably conflicting objectives of keeping energy prices down to protect the competitiveness of EU industry, reducing CO2 emissions to meet the EU's Kyoto emission reduction targets, and limiting Europe's dependence on energy imports are increasing the unpredictability of the political and regulatory environment, further increasing business risk.

• Security of supply concerns are increasing, and will stimulate upstream and midstream gas investment and merger & acquisitions activity, with EU fuel import dependency rising as indigenous oil and gas reserves continue to deplete.

The complexity and interdependence of the emerging trends outlined above creates uncertainty over the future development of the European energy market. The exposure to these risks among utilities differs depending on their specific characteristics.

Scale and diversification in terms of product offering, fuel supply, generation capacity, geographical coverage, and regulatory exposure reduces the overall exposure to potential adverse changes—which is important when the uncertainty and potential for negative events increases. Large groups such as E.ON AG (AA-), RWE AG (A+), Enel SpA (A+), and Electricitée de France S.A. (EdF; AA-) are able to develop critical risk-mitigation skills in areas such as trading, procurement, R&D, and investments, as well as enhancing the ability to manage large investment projects and to smooth capital expenditure profiles.

IS GEOGRAPHY DESTINY?  Well-managed, vertical integration allows companies to reduce risks by ensuring access and control over important input and output factors, such as fuel supply and downstream market access. The increased volatility of electricity prices, as well as CO2 and oil and gas markets, means that trading skills, knowledge of the various commodities, and access to physical assets (in all types of commodities) will become more important. This will generally benefit the larger, diversified utilities, particularly those with integrated power and fuel operations, and will accelerate the trend for utilities to invest in upstream and midstream gas.

Political and regulatory relations will be decisive, but incumbents will likely be the most exposed to adverse actions. All types of utilities could be exposed to increased political and regulatory risks, which could result in adverse structural and fiscal measure affecting the utility sector. Although the larger companies could generally be expected to have the best political connections and the resources to handle the public-relation challenge, particularly if fully or partially state-owned, they're also likely to attract the most attention if they're perceived as generating large profits as a result of excessively high electricity charges to consumers or dominant market positions.

The geographical location of core operations will become a more important credit factor, benefiting Southern European utilities rather than Northern European utilities. This is because investments in the rapidly growing Southern European markets of Italy and Spain are needed to serve growing demand, and will entail lower business risk than if made in Northern or Western Europe, where demand is stagnating and investments are needed mainly to replace aging capacity.

EXPECT VOLATILE CYCLES.  This lower market and operating risk is already incorporated in the ratings of incumbent utilities such as Iberdrola S.A. (A+), Endesa S.A. (A), and Enel, while Standard & Poor's incorporates the generally higher operating and regulatory risks in its ratings on Northern European utilities.

With deregulation, investment risk has increased, as it will likely result in more volatile cycles. Deregulation, the uncertainty over energy policy, and volatile fuel and power market conditions means generation investments are now more risky than they were under the more predictable regulated regimes. This is likely to result in more cautious behavior, encouraging smaller and shorter lead-time incremental investments. For example, this has favored combined cycle gas turbine (CCGT) generation, which is less capital-intensive, more flexible, and has a shorter lead-time than larger scale, more capital-intensive investments in coal-fired and nuclear generation.

This trend has, however, only exacerbated the EU's gas-import dependence and security-of-supply concerns. The oil and gas price surge seen in recent years, which has improved the competitive position of coal-fired generation, illustrates how the investment environment can rapidly change. Demand growth and stability has increased in importance as a ratings factor following the liberalization of markets in Europe. This is factored into the business risk of utilities in S&P's ratings.

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