Utilities – rock or victim of the energy crisis?

In the current difficult market environment, the defensive utilities sector should actually perform above average. However, the Stoxx 600 Utilities Index has also declined slightly since the beginning of the year. Only regulated utilities without major risks have been able to perform well. It seems that the markets have focused too much on the risks and too little on the opportunities.

The primary political goal is to become independent of Russian energies such as oil, gas or coal as quickly as possible without endangering supply security. The expansion of renewable energies must be accelerated accordingly. Germany, for example, has adopted a series of measures as part of the so-called Easter Package, such as more new areas for photovoltaics and wind as well as streamlining planning and approval procedures. By 2030, at least 80 percent of Germany's electricity consumption is to come from "renewables". In addition to wind turbine manufacturers such as Vestas or Siemens Gamesa, renewable energy providers such as Acciona Energias, EdP Renovaveis, Neoen or Orsted should benefit from an accelerated expansion of renewable energies. Orsted is one of the largest operators with a current capacity of 12.7 GW and is well positioned in larger offshore wind farms. The Danes plan to expand capacity to 50 GW by 2030.

RWE between opportunities through renewables and risks through coal embargo

RWE is also interesting, as it is developing into a pure supplier of renewable energies after the phase-out of coal (a spin-off may be possible in the next few years) and nuclear power. Accordingly, the valuation discount to other renewable energy providers should narrow. In addition, the company is financially well positioned with a net cash position of EUR 360 million at the end of 2021. Already for this year, RWE forecasts an EBITDA

contribution of 70 percent from renewables. RWE currently has 9.5 GW of renewable energy capacity and, like Orsted, aims to expand this to 50 GW by 2030. RWE is also benefiting in part from higher electricity prices. In general, the Essen-based company only hedges 80 to 90 percent of its electricity generation. In addition, part of the production from "renewables" is not contracted long-term and can thus be sold at high prices on the spot market. In the first quarter, the electricity price averaged 185 EUR/MWh. In view of such high electricity prices and a rather conservative guidance for Supply & Trading, the outlook could be adjusted upwards again in the course of the year. Risks, on the other hand, could arise from the coal embargo. RWE purchases twelve million tonnes in the long term and two million tonnes until March 2023 from a Russian supplier. It is unclear whether force majeure applies here. If it really is a case of "force majeure" (after all, the embargo is politically desired and RWE cannot obtain coal from Russia because of it), RWE would not have to meet its delivery obligation. Otherwise, the coal would have to be purchased elsewhere, which would be very expensive at the current coal price of almost 300 USD per tonne.

Integrated utilities are also investing heavily in the expansion of renewable energies. Valuations are comparatively moderate with a P/E ratio for 2022 of 8 for Engie, 11 for Engie and 16 for Iberdrola, and the dividend yield is significantly higher. At just under 50 per cent, Iberdrola has the largest share of profits from renewable energies. Last year alone, the Spanish company commissioned 3.5 GW of new capacities. A further 7.8 GW of capacity is under construction, 2.6 GW of which is in the fastest-growing offshore wind segment. 46% of EBITDA also comes from the regulated network business.

Expansion of renewable energies will become significantly more expensive

In view of higher material costs for steel, among other things, and rising interest rates, the expansion of renewable energies will become significantly more costly. Independence from cheap Russian gas thus comes at a high price and, especially for energy-intensive industries such as chemicals, steel or glass, should result in long-term locational disadvantages, particularly vis-à-vis the USA (cheap oil and gas from fracking) and China (future buyer of cheap Russian gas). In order to keep electricity reasonably affordable, it will therefore be difficult to do without nuclear power as a bridging technology. Some countries, such as Belgium or Finland, are already reacting by extending the lifetimes of nuclear reactors. This buys time for the energy transition. It remains to be seen to what extent Germany will follow suit. There seems to be no rethinking in sight yet, or at least some of the government partners in the traffic light coalition are having a hard time with such a rethink. In any case, extending the operating lives of the three nuclear power plants still in operation, Isar I, Emsland and Neckarwestheim, would make sense both economically (cheap base load generation) and ecologically (no CO2 emissions). In view of the already scarce capacities and the high electricity and gas costs, it would make sense to continue operating the reactors for a limited period of time, e.g. five years. Otherwise, the annual production of 30 to 35 terrawatt hours TWh (about five per cent of Germany's electricity consumption) would have to be additionally replaced in an already very tight market, which would lead to further increases in electricity prices. Theoretically, it would also be possible to reactivate the reactors that were already shut down last year. However, this would be costly. The reactors are already in the decay phase, so extensive maintenance work would be necessary. In addition, a new operating licence would be required. On the other hand, additional capacities would enter the market. This would correspond to five percent of total electricity production. This should have a relieving effect on the electricity price.

Decentralised expansion of the electricity grids is crucial

Parallel to the expansion of renewable energies, however, the electricity grids must also be expanded. In addition to large power lines, a decentralised expansion of the distribution grids is crucial. E.ON, for example, should benefit from this. The forecast sustainable profit growth of three to five percent p.a. should increase accordingly. However, the relatively high debt of five times EBITDA is a certain obstacle. The share has come under significant pressure due to its Russia risk. The value of the share in Nordstream I held in the pension fund is questionable. However, the book value of EUR 1.2 billion corresponds to only four per cent of the market capitalisation. Although E.ON itself does not purchase gas directly

from Gazprom, it has the largest exposure in Europe with 380 TWh of supply obligations to end customers such as private households or large companies. Since Germany obtains more than 50 per cent of its gas needs from Russia, it is likely that most of E.ON's suppliers would default. If no more Russian gas were to flow, this would therefore threaten the existence of the country. However, the government is aware that a gas embargo would have incalculable economic consequences and would plunge Germany into an unprecedented recession with severe distortions on the labour market and the permanent migration of entire industries, especially energy-intensive ones.

The danger remains that Gazprom itself will stop deliveries. However, this is rather unlikely, as Russia is dependent on foreign currency. Moreover, unlike coal or oil, gas cannot be sold to other customers such as China or India without existing pipelines. After the completion of the "Power of Siberia 1" pipeline with a transport capacity of about 61 billion bcm (bcm = trillion cubic metres) to China, a new pipeline "Power of Siberia II" with an additional capacity of 50 billion bcm is being built, but the construction is costly and lengthy (the construction time of the first gas pipeline was five years).

If gas were to stop flowing from Russia after all, Germany would have to switch to forced management with rationing of gas purchases for industrial companies and private households. In this case, force majeure would apply, which would mean that companies like E.ON would be released from their supply obligations. Nor would it be possible to stock up on such large volumes of gas to replace Russian gas. The reduction in the use of fossil fuels will lead to a permanently high electricity price, which in turn should benefit suppliers with electricity generation that is independent of fossil fuels, such as hydropower or nuclear power.   

Exaggerated share price declines

The share price slide at Fortum and Uniper also seems exaggerated. Both companies have the greatest exposure to Russia in Europe. In contrast to other European utilities, they own majority stakes in Russian subsidiaries, which account for about a quarter of their profits. Furthermore, Uniper's stake in Nordstream II, worth one billion euros, is to be written off completely with the stop. In addition, Uniper purchases around 160 bcm of gas from Gazprom, which in the worst case would threaten its existence. However, the same applies here as with E.ON. On the one hand, it is very unlikely that Russia will impose a gas embargo or a supply freeze. Secondly, force majeure would probably apply in this case. The almost 50 percent drop in the share prices of both utilities since the beginning of the year therefore seems exaggerated. Especially since both should benefit from permanently high electricity prices due to their high share of electricity generation from water and nuclear power in Scandinavia. In the case of Uniper, moreover, a buyout of the minorities by Fortum, which already owns more than 75 percent of the shares, should be a real option. As the majority shareholder, one is liable for possible risks of a Russian gas supply stop anyway, but could use the current favourable level to finally gain full control and conclude a domination agreement.

Focus too much on risks

It remains to be said that the market is currently still focused on the risks. Above all, a gas embargo would have serious consequences for a large number of utilities, above all E.ON and Uniper. However, as described, a supply freeze is unlikely due to the serious consequences and would have to be considered a force majeure if the worst came to the worst. At present, the only option is a coal embargo. This is more of a symbolic policy that does not really harm Russia. On the contrary: coal can be stored well, and Russia can ship the coal it does not buy to other countries such as China or India at a much higher price (estimated at 40 to 50 USD more compared to the current market price per tonne of just under 300 USD). The next conceivable step would be the frequently demanded oil embargo. The main beneficiaries would be oil companies such as Total or Royal Dutch as well as large US companies such as Chevron, Exxon, Occidential Petroleum or Conoco Philipps. In spite of everything, Russian oil would find buyers such as China or India. After all, an oil embargo would not have any negative effects for suppliers.

Besides embargoes, state intervention is feared. However, larger interventions such as a cap on electricity or gas prices do not seem to be on the cards. The focus is on smaller national interventions, as in Italy or Spain, with no major impact on local suppliers such as Enel or Iberdrola. The focus is rather on state support for low-income households, which are particularly affected by the rise in electricity and gas prices.

Thus, interesting entry opportunities are likely to present themselves with providers of renewable energies that profit from an accelerated expansion as well as with companies that have come under too much pressure due to their Russia risk. The politically desired increasing independence from Russia's cheap fossil fuels will lead to a permanently high electricity price, which in turn should benefit utilities with electricity generation that is independent of fossil fuels, such as hydropower or nuclear power.         

Note: This is a marketing advertisement. Please read the prospectus of the relevant fund and the KIID before making a final investment decision. These documents can be obtained free of charge in German at www.dje.de under the relevant fund. A summary of investor rights can be accessed in German free of charge in electronic form on the website at www.dje.de/summary-of-investor-rights. The funds described in this marketing announcement may have been notified for distribution in different EU Member States. Investors should note that the relevant management company may decide to discontinue the arrangements it has made for the distribution of the units of your funds in accordance with Directive 2009/65/EC and Article 32a of Directive 2011/61/EU. All information published here is for your information only, is subject to change and does not constitute investment advice or any other recommendation. The sole binding basis for the acquisition of the relevant fund is the above-mentioned documents in conjunction with the associated annual report and/or the semi-annual report. The statements contained in this document reflect the current assessment of DJE Kapital AG. The opinions expressed may change at any time without prior notice. All information in this overview has been provided with due care in accordance with the state of knowledge at the time of preparation. However, no guarantee or liability can be assumed for the correctness and completeness.