Polenergia Market is pricing in no regulatory change and the worst case (and unlikely) scenario

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1 EQUITY 26 February 2015 Electric Utilities Initiation of coverage Poland Polenergia Market is pricing in no regulatory change and the worst case (and unlikely) scenario Buy Price 24/02/15 PLN m target PLN45.1 Upside to TP 59.4% 12m f'cast div na 12m TSR Go to SG website Sector stance OVERWEIGHT Preferred stock PGE, Energa Least preferred stock Tauron, Enea Share price performance Feb-14 May-14 Aug-14 Nov-14 We initiate our coverage of Polenergia with a Buy recommendation and a target price of PLN45.1. Our TSR of 59% reflects the potential we see in the introduction of the new RES regulations in Poland and its positive impact on domestic green certificate prices. An integrated, independent, renewable energy source (RES) power group in Poland: Thanks to the lack of state-control over the business, Polenergia remains somewhat immune to all the developments currently hurting utilities in Poland their potential consolidation and their commitments to the mining sector. Polenergia is the most experienced wind farm developer in Poland, and it has built more than 10% of Poland s renewable energy operating capacity. It should build an additional 151MW by year-end, and a further 678MW should be eligible for the new auction system out to The key story is the new RES regulations to be introduced in Poland: We believe this will effectively eliminate the oversupply of green certificates, and boost their prices considerably by the end of the decade (to 80% above current spot prices). We calculate that Polenergia s current stock market valuation assumes green certificate prices remain at spot levels forever and that competition under the new auction system will wipe out any potential premium to be earned over WACC while it develops RES installations. In our view this is a worst case scenario and one unlikely to materialise. Our central scenario assumes green certificate prices rise to PLN270/MWh in 2020e from the current spot of ca. PLN150/MWh. Growth to outpace peers: No other utility in our coverage universe offers similar growth potential: we expect EBITDA CAGR of 24% and net income at 19% until 2020e. Positive CO 2 exposure: Given its carbon-free electricity generation potential, Polenergia shares should be positively correlate with any CO 2 price increases and gain support from an earlier introduction of the MSR system. We value the stock at PLN45.1, which gives a 12m TSR of 59% (we expect no dividend until 2017), hence our Buy rating. We use a WACC based on a 2.5% risk-free rate, 5% market risk premium, beta of 1.1 and cost of debt of 5.5%. We assume 70% debt financing for wind farms and 50% for other operations (which yields WACCs of 5.5% and 5.8%, respectively). The main risks: No recovery in green certificate prices, competition in the feed-in-tariff auctions, falling CO 2 and electricity prices, inability to deliver wind farm projects, subdued load factors. Share data Financial data 12/13 12/14e 12/15e 12/16e Ratios 12/13 12/14e 12/15e 12/16e RIC PEPP.WA, Bloom PEP PW Revenues (PLNbn) P/E (x) na na week range EBIT margin (%) FCF yield (/EV) (%) EV 14 (PLNm) 1,642 Rep. net inc. (PLNm) Dividend yield (%) na na Mkt cap. (PLNm) 1,285 EPS (adj.) (PLN) Price/book value (x) na na Free float (%) 5.3 Dividend/share (PLN) EV/revenues (x) na na Performance (%) 1m 3m 12m Payout (%) EV/EBIT (x) na na Ordinary shares Interest cover (x) EV/IC (x) na na Rel. Eurofirst Net debt/equity (%) ROIC/WACC (x) na Equity analyst Bartlomiej Kubicki (48) CAGR 13-16e: +35.2% Societe Generale ( SG ) does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that SG may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE APPENDIX AT THE END OF THIS REPORT FOR THE ANALYST(S) CERTIFICATION(S), IMPORTANT DISCLOSURES AND DISCLAIMERS AND THE STATUS OF NON-US RESEARCH ANALYSTS.

2 Polenergia Valuation (PLNm) 12/09 12/10 12/11 12/12 12/13 12/14e 12/15e 12/16e Nb. of shares basic year end/outstanding na na na na Share price (average) Average market cap. (SG adjusted) (1) ,285 1,285 Restated net debt (-)/cash (+) (2) na na na na ,358-1,123 Value of minorities (3) na na na na Value of financial investments (4) na na na na Other adjustment (5) na na na na EV = (1) - (2) + (3) - (4) + (5) na na na na na na 2,643 2,408 P/E (x) na na na na na na Price/cash flow (x) na na na na na na Price/free cash flow (x) na na na na na nm nm 5.48 Price/book value (x) na na na na na na EV/revenues (x) na na na na na na EV/EBITDA (x) na na na na na na Dividend yield (%) na na na na na na Per share data (PLN) SG EPS (adj.) na na na na Cash flow na na na na Book value na na na na Dividend na na na na Income statement (PLNm) Revenues na na na na 1,118 2,593 2,649 2,868 Gross income na na na na EBITDA na na na na Depreciation and amortisation na na na na EBIT na na na na Impairment losses Net interest income na na na na Exceptional & non-operating items Taxation na na na na Minority interests na na na na Reported net income na na na na SG adjusted net income na na na na Cash flow statement (PLNm) EBITDA na na na na Change in working capital na na na na Other operating cash movements Cash flow from operating activities na na na na Net capital expenditure na na na na ,171-2 Free cash flow na na na na , Cash flow from investing activities na na na na Cash flow from financing activities na na na na Net change in cash resulting from CF na na na na Balance sheet (PLNm) Total long-term assets na na na na 1,253 1,837 2,915 2,766 of which intangible Working capital Employee benefit obligations na na na na Shareholders' equity na na na na 892 1,334 1,413 1,508 Minority interests na na na na Provisions na na na na Net debt (-)/cash (+) na na na na ,358-1,123 Accounting ratios ROIC (%) na na na na na ROE (%) na na na na na Gross income/revenues (%) na na na na EBITDA margin (%) na na na na EBIT margin (%) na na na na Revenue yoy growth (%) na na na na na nm Rev. organic growth (%) na na na na EBITDA yoy growth (%) na na na na na EBIT yoy growth (%) na na na na na EPS (adj.) yoy growth (%) na na na na na Dividend growth (%) na na na na na na na na Cash conversion (%) na na na na 88.3 nm nm nm Net debt/equity (%) na na na na FFO/net debt (%) na na na na Dividend paid/fcf (%) na na na na 0.0 nm nm February

3 Contents Group anatomy Business overview... 4 Share price drivers... 5 Valuation... 6 Investment summary... 7 An independent, integrated renewable energy-based power group in Poland... 7 An unmatched growth outlook... 8 Rising green certificate prices the key... 8 Competition in the auction system also affects the valuation... 8 On the other hand, experience will help... 8 Positive CO2 and coal exposure... 8 The current valuation seems to price in a worst case scenario... 9 Company description PEP and Polenergia deal Group strategy Polenergia s assets and projects Financial performance Key theme Exposure to renewable energy Overview of old and new regulations for renewable energy sources (RES) in Poland Calculation of feed-in-tariffs for wind installations base case Summary of estimates Valuation Sensitivity to key assumptions February

4 Group anatomy Business overview Sales/division 2013 EBIT/division 2013 CHP 30.8% PEP 12.5% Distribution 7.5% Others 3.1% Pro forma 2013 financial statements: electricity sales dominate... PEP 23.9% Distribution 11.3% Electricity sales 5.3% Others %...yet its profitability remains low (PEP=wind farms and biomass) Electricity sales 46.1% CHP 70.6% Wind farms segment development EBITDA margin ex trading Profits and revenues from wind farms should be rising rapidly thanks to pipeline development 60% 50% 40% 30% 20% After adjusting for trading, EBITDA margins increase significantly % e 2015e 2016e 2017e 2018e 2019e 2020e 0% e 2015e 2016e 2017e 2018e 2019e 2020e Rev enue EBITDA EBITDA margin of wind farms Expected undersupply of green certificates 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% e 2015e 2016e 2017e 2018e 2019e 2020e Wind farms is a high margin business The new RES regime cutting the supply of green certificates should have a positive impact on prices and hence the valuation of Polenergia Source: Polenergia 26 February

5 Share price drivers Polenergia. Historical share price performance Commitment of CEE partners price (PLN), Bloomberg Best estimates Different scenarios for the share price 2016 green certificate price PLN % PLN % Current share price SG scenario PLN % PLN % 12-m horizon Risks to our central scenario TP impact Key share price catalysts Bull (1) LT green certificate prices up PLN10/MWh (2) LT CO2 prices up EUR1/t (3) WACC premium on feed-in-tariffs 1pp above base case Bear (1) LT green certificate prices down PLN10/MWh (2) LT CO 2 prices down EUR1/t (3) WACC premium on feed-in-tariffs 1pp below base case PLN0.9 PLN0.7 PLN3.9 PLN0.9 PLN0.7 PLN3.9 Positive Green certificates prices increase CO2 prices increase Rising coal prices Negative Persistent oversupply of green certificates Competition between wind farms in auctions Falling CO 2 prices 26 February

6 Valuation Sector valuation Share Target 12mf cast 12m Market EV/EDITDA P/E price Reco price divi TSR % cap. EV e 2015e e 2015e ROIC 24/02/2015 Drax Sell p p p ,740m 3,025m E.ON Buy ,845m 63,338m EDF Buy ,286m 108,868m Endesa SA Buy na na 18,109m 29,390m Enea Hold PLN16.30 PLN17.20 PLN PLN7,196m PLN7,423m Enel Buy ,196m 66,787m Energa Buy PLN21.60 PLN28.30 PLN PLN8,944m PLN3,504m Energias de Portugal Sell ,741m 32,131m Fortum Sell na na 18,096m na nm Iberdrola Hold ,064m 64,833m National Grid Sell p p p ,856m na nm Polenergia Buy PLN28.3 PLN45.1 PLN0 59% PLN1,285 PLN1,642 nm nm 13.4 nm nm Polska Grupa Energetyczna Buy PLN20.00 PLN24.60 PLN PLN37,395m PLN35,213m Red Electrica Hold ,222m 10,143m Redes Energeticas Nacionais Hold ,453m 3,417m RWE Hold ,108m 60,101m nm SSE Sell p p p ,596m na nm Tauron Hold PLN4.86 PLN5.60 PLN PLN8,517m PLN2,730m Terna Hold ,024m 13,295m Verbund Buy na na 5,906m 10,379m February

7 Investment summary An independent, integrated renewable energy-based power group in Poland The largest wind farm developer in Poland with (almost) no political risk attached, as opposed to the other integrated Polish utilities Polenergia is the largest, privately owned and integrated energy group in Poland, with a keen focus on the development of renewable (onshore and offshore wind) projects as well as regulated distribution networks of gas and electricity. Polenergia is the most experienced wind installations developer in Poland and has already developed capacity of more than 400MW, most of which has been sold, and 146MW is currently being operated by the company. Moreover, the group plans to operate 297MW of electricity generation capacity in onshore wind farms by end-2015 before the new auction system and feed-in-tariffs are introduced in Poland, so as to benefit from the rise in green certificate prices that is likely to result from their shrinking future supply. Moreover, the company plans to have an additional 678MW of wind installations by end 2018 to take part in the new auction system. Furthermore, Polenergia, together with PGE, is at the most advanced stage of offshore wind farm project development in Poland. Polenergia aims to erect Baltic Sea capacity of 1.2GW of wind capacities by end-2026 (our modelling does not include all these). Apart from the wind farm segment, which we expect will soon contribute the majority of group EBITDA (SGe: >80% on average from 2016 to 2020), Polenergia operates a CCGT CHP (116MW of installed electricity generation capacity), and a small distribution business (regulatory asset base of around PLN50m). The company is also developing a Germany- Poland gas interconnector with total capacity of 5bn m 3, and has in its pipeline two conventional, hard-coal-fed, 800MW power generation projects in Poland. Existing and development assets of Polenergia, Polenergia 26 February

8 An unmatched growth outlook We are looking for EBITDA and net income CAGR of 24% and 19% respectively until 2020e Polenergia offers growth potential no other utility group can match in Poland. Thanks to new projects as well as the anticipation of uptrending green certificate prices, we project a CAGR in EBITDA of 24% out to 2020e, with the bottom line growing 19%. Rising green certificate prices the key We believe that new regulations will boost green certificate prices and should considerably lift Polenergia s valuation Over the next few days, Poland should see the introduction of new Renewable Energy Source (RES) regulations. As a result, installations commencing electricity production until end-2015 will operate under the current regime, which is based on green certificates (renewables generators get revenue from selling both electricity and green certificates). We do expect the shortcoming that plagues the current system i.e. an oversupply of green certificates to be addressed. Biomass co-combustion boilers (where biomass share in the calorific content of the fuel is below 20%) will have their green certificate grants cut by half to 0.5 per 1MWh and large hydro plants (>5MW) will no longer receive any certificates. As a result, the supply of green certificates will fall and for biomass co-combustion plants to operate, certificate prices will have to rise to about PLN270/MWh (vs the current spot price of PLN150/MWh), which we estimate is their break-even point. Furthermore, new regulations are also aimed at boosting demand for green certificates amid tepid power consumption increases. Our valuation of Polenergia (PLN45.1 per share) is very sensitive to our key assumption of green certificate price convergence as 70% of the calculated enterprise value is derived from wind farms operating and scheduled to operate under the old RES regime. We note in this report that if green certificate prices remain at current levels (a very unlikely scenario in our view) until the end of this support system (2030), the company s valuation in total falls by 30%. Competition in the auction system also affects the valuation We think Power groups will be able to earn a premium over WACC in the new feed-in-tariffs system. Should there be no premium, we see the TP falling to PLN42.9 per share Our central scenario assumes that the feed-in tariff which is determined by a reverse auction against a reference price that is itself based on average market assumptions will earn a 1pp premium above an (implied) WACC. Although the valuation of wind farms to operate in the new RES regime constitutes a minority (9%) of our base case valuation for Polenergia, the premium above WACC on these installations is a critical value driver. Should the price auction wipe out any of that premium earned above WACC, our valuation of this segment could fall as much as 80% vs our central case, leading to an 8% overall contraction in our share price target. On the other hand, experience will help Experience should help to earn higher IRRs in the new auction system The key to success with the new auction system is to have a competitive edge. This comes down to having higher load factors on the wind farms, getting access to cheaper financing, or working with lower capex and lower opex. This competitive edge comes with experience, and with Polenergia on the market for years in Poland we are confident that it can carry off at least one of these competitive factors be done better than the competition thereby beating the benchmark for the feed-in-tariffs calculation and increasing its chances of winning the auction. Polenergia is a clean energy producer, hence any CO2 prices rise have a positive impact on its profits Positive CO2 and coal exposure Polenergia is a clean electricity generation company with its fleet based predominantly on wind electricity generation installations. As a result, its CO 2 intensity will be close to zero and its wind farms, which still operate under the old RES regulations, will offer decent exposure to potentially rising CO 2 prices. We estimate that a 1/t increase in the long-term CO 2 price lifts 26 February

9 the company s valuation by 1.5%. Similarly, electricity prices in Poland are linked to domestic coal prices which allow Polenergia to benefit from any future coal price increases without incurring fuel costs. The current valuation seems to price in a worst case scenario We think the current share price reflects the worst-case scenario no increase in green certificate prices On our estimates, the current share price valuation not only assumes no green certificate price recovery, but also competition so fierce that it prevents wind park developers from earning any premium above their cost of capital (or else it assumes a price recovery, but does not factor in the company s potential to add new wind farms to its operating portfolio). We think these are worst case scenarios. We value the company at PLN45.1 per share, which, given the current share price, offers 59% upside potential, and hence our Buy rating. We use a WACC based on a 2.5% risk-free rate, 5% market risk premium, beta of 1.1, and a cost of debt of 5.5%. We assume 70% debt financing for wind farms and 50% debt financing for the other operations (which yields WACC of 5.5% and 5.8%, respectively). Downside risks: No recovery in green certificate prices, competition in the feed-in-tariffs auctions, falling CO 2 and electricity prices, an inability to deliver projects within parameters (opex, capex, load factor, cost of debt) that are inferior to the benchmark employed to calculate the reference feed-in-tariff, subdued load factors. Valuation of Polenergia (PLN per share) Wind farms old RES regime Wind farms new RES regime ENS, other PEP, distribution Off-shore wind farms Gas pipeline project Net debt 2014-end Value per share 26 February

10 Company description Private, integrated, green Today s Polenergia was born from the 18 August 2014 transaction between Polish Energy Partners and Polenergia Holding, which created a vertically-integrated energy group in power generation (conventional and predominantly renewable), electricity distribution and trading. Polish Energy Partners was listed on the Warsaw Stock Exchange in 2005 and was predominantly involved in the implementation of power engineering projects based on renewable energy sources. In 2012 the company was taken over by Polenergia Holding. Polenergia Holding, in addition to developing conventional and renewable energy-sourced electricity generation projects, is also involved in electricity distribution, trading and sales to end-customers. PEP and Polenergia deal Polenergia s current status is the result of the former Polish Energy Partners (PEP) performing a PLN557m capital increase in exchange for an in-kind contribution of Polenergia assets (16,863,458 new shares issued). Subsequently, another PLN240m of new capital was issued (7,266,122 new shares) with all the shares being acquired by the CEE Equity Partners SPV, Capedia Holdings Limited. Polenergia s assets were independently valued at PLN557m and PEP at PLN704m, resulting in a valuation per share of PLN33.03 which became the new capital issue price for CEE Equity Partners. Assets of both Polenergia and PEP were assessed by the new investor as well as financial advisors issuing two independent fairness opinions. Valuation of Polenergia s net assets Asset PLNm Elektrownia Nowa Sarzyna 195 Project Green (offshore) 146 Polnoc Power Plant 75 Polenergia Obrot 65 Polenergia Dystrybucja 57 Project Hans (gas pipeline) 40 Polenergia Kogeneracja 2 Others -23 TOTAL February

11 As a result of the above transactions, which took effect on 18 August 2014, the following group structure has been created: Polenergia group post merger structure after issuing shares to CEE Capital Partners Additionally, current shareholders of Polenergia have approved a potential capital increase via a public offer where no more than 12,685,429 new shares could be issued. Any potential capital increase is subject to funding needs, which have decreased since the decision was taken on the back of lawmakers assuming a transition period between the new and old renewable energy regulations. Current shareholder structure Aviva OFE 7% Others 5% Generali OFE 6% CEE Equity 16% Kulczyk Investments 66%, Polenergia 26 February

12 Dividend policy Management expects the first dividend to be paid from 2017 onwards. There is no payout guideline in place though. Group strategy Focused on a rapid development of wind farms Polenergia s long-term strategy is the creation of an integrated power group present in all energy market segments with a particular focus on the development of renewable energy installations as well as regulated electricity and transmission distribution networks. The group plans to operate 297MW of electricity generation capacity in onshore wind farms by end-2015 (vs the current operating assets portfolio consisting of five wind farms with total capacity of 146MW). On top of that, Polenergia owns another 678MW of wind power projects, of which 284MW is up for the first auction (probably in 2016) under the new renewable energy regime in Poland. The company also plans to build 600MW in offshore wind capacity by end and another 600MW by end The group assumes that it will develop its offshore wind projects with a potential JV partner (on a 50/50 basis); however, a disposal of offshore projects cannot be excluded. A similar approach is taken towards the conventional, thermal coal power plant project (Polnoc Power Plant). Capacity development projections Source: Polenergia Polenergia s assets and projects Polenergia s portfolio of commissioned and running projects consists of 146MW of wind generation capacity located in Poland (of which 66Mw completed in Q4 14), a CCGT power plant in Nowa Sarzyna, electricity distribution assets, pellet production and trading for biomass-fuelled power block assets, and some energy outsourcing activities. Existing wind generation capacity The company s key operational wind assets comprise five onshore wind farms with a total generation capacity of 146MW in Puck, Modlikowice, Lukaszow, Gawlowice, and Rajgrod with the last two commissioned within slightly less than one year since construction commenced. Puck was commissioned back in 2006 and sells electricity to Energa and Polenegia, while both Lukaszow and Modlikowice were commissioned in 2011 and provide electricity to Tauron. Those assets generated 193.4GWh of gross electricity in 2013, are entitled to receive 26 February

13 green certificates of origin per each MWh of gross electricity produced and have an estimated average long-term load factor of 27%, although the 2013 gross load factor amounted to 23.3% on our estimates. Gawlowice and Rajgrod were delivered in Q4 14 and are expected to operate on an average load factor ranging between 33% (Rajgrod) and 40% (Gawlowice). The higher load factors of those two vs Polenergia s older, completed projects is due to improved wind turbine technology and windier locations. Existing and operating wind farm assets Wind farm Installed capacity (MW) LT average load factor 2013 Load factor Commissioning year Puck 22 22% 21% 2006 Lukaszow 34 29% 25% 2011 Modlikowice 24 28% 23% 2011 Gawlowice 41 40% N.A Rajgrod 25 33% N.A. 2014, Polenergia Despite having only five operating wind farms, the company has been developing renewable energy projects since early 2000 and in total developed 448MW of wind farms (of which 302MW has been sold) and is currently constructing one farm with a total generation capacity amounting to 37MW scheduled to be operating by the end of this year. Existing wind farm production track record (GWh) Wind farm development track record (MW) Puck Lukaszow Modlikowice, Polenergia Sold Commissioned Construction stage Cumulativ e 486 Wind farm projects at the advanced stage of development and construction The new RES law stipulates that projects completed by the end of 2015 will continue tooperate under the old regime, in which electricity generation is compensated both by the price for electricity and the green certificate awarded for electricity produced. As a result, Polenergia has accelerated the development/construction of new wind parks and intends to commission an additional 151MW of wind installations in order to benefit from the assumed increase in green certificate prices (thanks to supply cuts resulting from the new regulations). 26 February

14 Wind projects to be delivered under the old renewable energy regime Project Capacity (MW) LT load factor Completion time Gawlowice - extension 7 37% 2015 Skurpie 37 36% 2015 Skurpie - extension 7 36% 2015 Mycielin 48 37% 2015 Pieklo 12 34% 2015 Grabowo 40 39% 2015 TOTAL % Onshore wind development pipeline For the upcoming auction process (which should begin in 2016 we believe), 678MW of wind farms should be ready, with the first installations up and running from 2018 (our base case). We estimate that 42% of Polenergia s projects should be ready for the first auction (or auctions taking place in 2016). Percentage of projects to be ready for upcoming auctions (out of 678MW total) % %, Polenergia % Offshore wind farm projects The company believes, and we share this view, that in order to comply with the European Union s requirements concerning electricity production coming from renewable sources (27% on average until 2030) as well as a considerable CO 2 reduction as recently outlined in the 2030 Climate and Energy Package, Poland will have to develop offshore wind farms. Polenergia plans to develop and build two projects on a 50/50 JV-basis (alternatively they could be sold before construction begins) with a combined planned capacity totalling 1.2GW located on the Baltic Sea. This is to be evenly split between two projects (Baltyk Srodkowy II and III) located from 22km to 37km from the Polish shore. Polenergia is still developing these projects and expects to have regulatory approval granted in Clearly, this project is subject to the new renewable energy act (described in the regulation section of this report) and a potential support for offshore wind generation. Polenergia expects construction capex to reach almost 4bn, whereas development capex is seen at PLN m. Both projects already have site permits, environmental scoping, and the terms and conditions to connect to the transmission system have been agreed. 26 February

15 Polenergia s offshore wind projects Project Baltyk Srodkowy III Baltyk Srodkowy II Planned capacity (MW) Number of turbines c100 c100 Distance to the shore (km) Net area (km2) Depth (m) Average wind speed (m/s) Environmental decision expectations Q1 16 Q3 16 Start of construction End of construction Construction capex ( bn)* Construction capex per MW ( m)* , Polenergia; *the company plans to either dispose of the projects or to develop them on a 50/50 basis with a JV partner In addition, Polenergia has a permit for a third-site of 1.6GW. We would highlight a few recent benchmark transactions in offshore wind farm projects. For instance, in August 2012 Dong Energy acquired a Gode wind project with a capacity of 584MW at a price of 260k/MW; Dong Energy bought the Race Bank project from Centrica for GBP50m, 580MW with no building consent for 100k/MW. These indicate potential upside to Polenergia s offshore wind farms projects assuming a comparable subsidy system in Poland. Gas fired CHP Polenergia owns a gas-fired CHP located in southeast Poland with electricity capacity of an estimated 116MW and thermal capacity of 70MWt. The plant has been operating since 2000 and on average produces 760GWh of electricity and 530TJ of heat. In addition to electricity and heat revenues and resulting yellow certificates of origin (granted for high-efficiency gas co-combustion), the plant s top line is also boosted by LTC compensation and gas compensation scheduled to be paid to the company until According to LTC regulations, guaranteed LTC compensation effectively sets the company s EBIT at zero as its calculation is based on balancing energy and heat sales with COGS and opex. Additionally, gas compensation and yellow certificates of origin are fully passed on to earnings before tax. Currently, the plant operates under the base-load regime; however, following the expiration of LTC and gas compensation (2020 when the plant is also expected to be fully amortised), Polenergia s management expects the plant (following a slight modernisation which could extend the plant s life another 15 years) to switch to a peak-load system, earning on the basepeak spreads. Electricity distribution Polenergia Dystrybucja is the group s distribution arm (and hence is fully regulated), something of a niche player on the Polish market, proving electricity to commercial users (shopping centres, office buildings, industrial plants, warehouses) and households. The company has electricity distribution capacity of 76MW which they expect to increase by another 11MW by end In 2013, the entity distributed 235GWh of electricity and sold 183GWh to 9,500 customers. Distribution revenues are fully regulated in Poland and very much based on the return on the Regulated Asset Base (RAB) calculated by the regulator. For Polenergia Dystrybucja, the RAB equals PLN49m and the company expects it to increase to PLN77bn thanks to the development projects undertaken. Furthermore, the company expects the return to be calculated on the fully-valued RAB in 2015, whereas, last year, 72% of the RAB was recognised when calculating the distribution tariff. 26 February

16 Polenergia s distribution assets Operating Development Total Electricity distribution capacity (MW) Electricity distribution volumes (GWh) c270 Power lines length (km) RAB (PLN mn) Number of projects , Polenergia Polenergia s distribution assets (lines and no. of projects) Source: Polenergia Electricity trading platform Polenergia Obrot trades electricity and natural gas as well as certificates of origin which the entity buys externally and from the group s renewable energy installations. In 2013, Polenergia Obrot traded 3.15Twh of electricity and 44m m3 of natural gas. Pellet plants Back in 2008, a project to supply the energy sector with pellets (biomass) was launched and three pellet plants were created to manufacture agricultural biomass, in particular from straw (please note the growing share of agricultural biomass in total biomass combusted, as required by Polish regulations). Annual production from those plants totals 140,000 tons and generated PLN55.6m of revenues last year. Polenergia s pellet plants Project Polnoc Plant Poludnie Plant Wschod Plant Location Sepolno Krajenskie Zabkowice Slaskie Zamosc Start of operations and Annual production (ths tons) Source: Company data; SG Cross Asset Research/Equity Outsourcing of energy Old Polish Energy Partners and today s Polenergia operate two assets, a CHP plants in Wroclaw with heat capacity of 29MWt, and a power plant in Walbrzych consisting of a gas-fed boiler with capacity of 8MW. Polenergia has a contract with Whirlpool for the consumption of energy produced in the former plant and for the consumption of electricity with WZK Victoria 26 February

17 from the latter. The first contract runs until October 2020 and the second until end Last year, total revenues generated from energy outsourcing activities came to almost PLN15mn. Biomass power plant Polenergia is currently developing a biomass power plant in Winsko, which is expected to be commissioned in 2019 with total installed capacity of 31MW and expected electrical efficiency of 33%. Poland-Germany interconnector Based on the idea of integrating the central European gas markets not only from the North to the South (as is currently taking shape to cover Poland, the Czech Republic, Slovakia, Hungary and Croatia, and to link LNG terminals in Poland and Croatia), but also from the West to the East, connecting Poland with Germany and further with Ukraine and Lithuania, Polenergia intends to build a new interconnector to connect the German Gaspool market area with the Polish gas network in north-east Poland. In all, Poland, the Czech Republic, Slovakia, Hungry and Ukraine consume roughly 85bn m3 of natural gas annually with imports from Russia covering around 63% (and 92% of all imports). Additionally, Central Europe currently lacks the capacity to diversify away from Russia or to fully integrate with Western Europe, and as a result, potentially to cut gas prices. Polenergia believes (and we share this view) that the ongoing expansion of the natural gas transmission infrastructure in the region provides an opportunity to leverage on that and to also create a West-East corridor to import gas from Germany (Germany gets only 30% of its gas from Russia and the rest comes from the North Sea, the Netherlands, and domestic production). In general, Germany has around 135bn m3 of gas transmission capacity, substantially exceeding domestic consumption needs. Therefore, via the construction of the Poland-Germany interconnector, Poland and the Czech Republic, Slovakia and Hungary via the North-South corridor will all be able to diversify gas deliveries away from Russia. We see further potential if transmission systems are extended so that both Ukraine and Lithuania join the corridors. Additionally, the construction of the Poland-Germany interconnector close to the LNG terminal in Poland currently under construction could enable further exports (at least virtually) to the west of Poland. As already mentioned, to leverage the potential integration of the gas systems in central Europe, Polenergia intends to build a new interconnector linking German Gaspool with the Polish gas system. The project is expected to have total capacity of 5bn m3 and should assure firm capacity and will allow for the physical flow of gas both from Western Europe to Poland and in the opposite direction. The total length of the pipeline would be approx 150km, 120km of which is to be built in Germany by Polenergia and operated by Polenergia, whereas the Polish part can only be built (given the regulations) by Gaz-System the Polish transmission system operator. Polenergia already has all the building permits for Germany, 50% of rights of way obtained along the route in Germany, entry/exit capacities agreed with German transmission system operators and a preliminary agreement on remuneration via distribution tariffs with the German regulator. What is missing on the Polish side, however, is the final decision undertaken by Gaz-System to build its portion, which is a political decision owing to the state-controlled status of the Polish transmission system operator. Polenergia expects the project to be completed in February

18 West-East corridor idea Interconnector Poland-Germany Source: Polenergia In terms of secured capacities, Polenergia already has 3.15bn m3 of firm capacity from the German system, which is not dependent on or supplied from Russia, and there is also a possibility of using additional capacity of 1.85bn m3. Having completed the project (total capex should hover around PLN1bn), Polenergia intends to earn its return from the distribution tariffs as well as gas trading and potentially on the spread between German and Polish gas prices. Elektrownia Polnoc thermal coal fired power plant One of the projects Polenergia Holding has bought to the merged entity is a thermal-coal power plant located in the north of Poland (an ideal location from the point of view of stability of the transmission system) comprising two 800MW blocks with efficiency exceeding 45%. At present, the project has 223ha of land secured, with the tender process completed for the construction of the first block (Alstom), the grid connection agreement signed, and a long-term fuel agreement in place with Bogdanka (conditional though on construction starting). Moreover, Polenergia is considering getting a strategic investor on board to develop that project. We currently view project probability as low given subdued electricity prices (we also think capex for such a project would be relatively higher than for instance Opole, Jaworzno or Kozienice currently under construction) given its greenfield rather than brownfield nature), as well as the fact that no rights support system is in place yet in Poland (although it is under discussion). 26 February

19 Location of Elektorwnia Polnoc in Poland Source: Polenergia Assets summary Existing and development assets of Polenergia, Polenergia 26 February

20 Financial performance Given that the merger is a very recent event that led to the creation of the new Polenergia, only pro forma 2013 and pro forma Q financial statements are available from the company. In 2013, Polenergia (if it had merged with PEP then) would have earned PLN1.19bn in revenues (o/w PLN140m from PEP), and EBITDA of PLN124m, EBIT of PLN66m and PLN38.5m on the bottom line. Polenergia 2013 pro forma financial statement PLN mn 2013 Revenues 1,118.0 Gross profit EBIT 66.1 EBITDA Net income 38.5 Gross profit margin 9.2% EBIT margin 5.9% EBITDA margin 11% EBITDA margin excluding trading 20% Net margin 3.4% Assets 1,318.1 Gross debt Net debt Net debt/ebitda 1.7, Polenergia Although the trading entity is the largest contributor to the top line of the consolidated company, it is actually old Polish Energy Partners (PEP, comprising onshore wind farms, pellet production and energy outsourcing) together with the CHP gas plant in Nowa Sarzyna that generate the vast majority of the EBITDA of the consolidated group. Segment revenues (2013, PLNm) Segment EBITDA (2013, PLNm) Polish Energy Partners CHP Nowa Sarzy na Distribution Trading Others Polish Energy Partners CHP Nowa Sarzy na 10 4 Distribution Trading Others -1, Polenergia 26 February

21 Segment EBITDA margin (2013) EBITDA contribution 35% 30% 32% Distribution 8% Trading 3% 25% 20% 21% Polish Energy Partners 34% 15% 12% 10% 5% 0% -5% Polish Energy Partners CHP Nowa Sarzy na 1% Distribution Trading Others -2% CHP Nowa Sarzy na 55%, Polenergia Most of the revenues of Old Polish Energy Partners derive (2013 figures) from production and sales of electricity and derived certificates of origin (green) as well as the production of pellets (biomass). PEP revenue contributors (2013) PEP revenue contributors (2013) Other 4% Heat 4% Energy 24% Pellets 40% Pellets Certif icates of origin, Polenergia Energy Other Heat Certif icates of origin 28% Yet, most of its gross profit contribution comes from wind energy generation gross profit split by segment 2013 gross profit split by segment Outsourcing 17% Pellets 4% Outsourcing Pellets Wind electricity Others -5.0, Polenergia Wind electricity 79% 26 February

22 Quick summary of Q314 figures Group Pro forma P&L In PLNm Q Q Total revenues ,013.7 Thereof Polenergia Obrot ,567.8 Gross profit EBITDA Normalized EBITDA Net income Normalized net income Gross margin 10% 4% EBITDA margin 14% 6% EBITDA margin excluding Polenergia Obrot 25% 26% Net margin 4% 2% thereof Polenergia Revenue 281 1,568 Gross profit 5 7 Gross margin 2% 0%, Polenergia The EBITDA improvement comes from distribution (PLN5.1m) thanks to rising distribution and electricity sales volumes, cost decrease in the biomass segment and better wind farm load factors. Conventional power generation (Nowa Sarzyna power plant, outsourcing) is the major EBITDA contributor, followed by the wind segment and electricity distribution). The top-line boost is the result of the electricity sales segment s performance, yet its impact on overall profitability is rather limited. Top-line performance by segment PLNm Q Q %yoy Conventional generation % Biomass % Wind farms % Distribution % Sales , %, Polenergia EBITDA by segment PLNm Q Q %yoy Conventional generation % Biomass % Wind farms % Distribution % Sales %, Polenergia 26 February

23 EBITDA contribution of key segments (Q1-3 13)* EBITDA contribution of key segments (Q1-3 14)* Distribution 8% Sales 1% Distribution 11% Sales 2% Wind f arms 30% Conv entional generation 60% Wind f arms 28% Conv entional generation 55% Biomass 1%, Polenergia; *before eliminations Biomass 4% We will provide our estimates for full 2014 and future years in the later section of this report. 26 February

24 Key theme Exposure to renewable energy Understanding the change in regulations for renewable energy sources in Poland is key to understanding Polenergia s investment case There are two key differences between Polenergia and the integrated utility groups we discuss in this report. Firstly, Polenergia is a private company, hence the political (but not the regulatory) risk is substantially lower. And as a result, the company is not at risk of encountering any issues related to sector consolidation or to a potential commitment to the mining sector in Poland, which is currently destroying Polish utilities attractive investment story (Polish Utilities growth and dividends on the table). Secondly, Polenergia s business model is mainly focused on the development of renewable energy sources, in particular wind installations, where we see returns to be generated in excess of the cost of capital. Under the current regulatory regime, for every MWh of electricity produced by wind generators, Polenergia receives payment for the electricity (linked to the market price) and one green certificate of origin, which at the end of the day is also influenced by market forces. However the price that certificate fetches in the market is capped at the redemption fee level. Although both power and green certificate prices have somewhat rebounded from their lows reported last year, the latter still sells at a substantial discount to the redemption fee (roughly PLN150/MWh vs the redemption fee of PLN300/MWh). This is a consequence of subdued electricity demand in Poland and predominantly a clear oversupply of green certificates of origin due to biomass co-combustion, which has been a cheap way for all power groups to develop green energy. Green technology discrimination is key to solving the excessive supply issue and lawmakers are very much aware of this issue. As a consequence, the Polish government aims to implement new regulations (still in the final approval process) to limit the supply of green certificates (no certificates from hydro generation, and only a half a certificate for biomass co-combustion, which basically makes the latter unprofitable at current market prices, and we estimate the breakeven price for the biomass energy to be co-combusted under the new regime at PLN /MWh). Regulations also aim to regulate demand (should the certificate price fall below 75% of the redemption fee, the option to pay the redemption fee is removed and certificates must be purchased on the market). According to the current draft of the new act, the URE (Energy Office Regulator) will influence demand by regulating the percentage of green certificates redeemed on the sale of electricity to end-customers. In sum, implementation of proposed and discussed regulations is likely to substantially cut the oversupply of certificates (in 2012 biomass co-combustion accounted for roughly 60% of total green certificates and hydro for 20%) and should lift certificate prices close (though probably with a slight discount) to the redemption fee level (our base-case assumes a gradual conversion to breakeven prices for biomass co-combustion). Additionally though this might sound a bit contradictory assuming that no new wind installations are commissioned from 2016 on for at least two years given the regulatory change and in order to comply with the agreements concerning green energy as a percentage of total energy production and the risk that Poland may not actually comply, at the of the decade Poland will have to boost biomass co-combustion to increase energy from renewable energy sources to achieve the country s targets. But this cannot be achieved without economics (i.e. green certificate prices) in favour of biomass co-combustion installation (i.e. > breakeven prices). We see that as another argument (apart from supply cut) that favours an increase in green certificate values. 26 February

25 Based on the current agreement struck by the Polish Parliament (one we do not think will change), the old regime will only apply to RES installations producing electricity by the end of this year (so the installations will be rewarded with electricity and green certificate revenues). Thereafter an auction system will go live with feed-in-tariffs in place. Overview of old and new regulations for renewable energy sources (RES) in Poland The green certificates regime should be maintained for RES installations commissioned until the end of Under the green certificates system, support would last 15 years and the substitution fee should be frozen at roughly the current level of PLN300/MWh. New regulations should eliminate the issue of green certificate oversupply by eliminating support for hydro power plants with installed capacity exceeding 5MW and reducing support for biomass co-firing to 0.5 certificates per 1MWh and the share of biomass in the fuel mix (calorific value) to below 20%. Polenergia assumes the reduction of certificates issuance to 50% thanks to changes in the regulations. In terms of the boost to demand for green certificates, the renewable obligation target for sales to end-customers should be set at 20% in 2016 (vs 15% according to the current regulations) and determined annually based on the projected amount of electricity to be generated by RES. Additionally, the option to pay the substitution fee will be removed should the certificate price fall on average below 75% of the fee value in the three months preceding the obligation fulfilment date. Green certificates supply and demand mechanics TWh P 2014P 2015P 2016P 2017P 2018P 2019P 2020P Green certificates demand Green certificates supply Green certificates overhang Source: Polenergia Auction/feed-in tariff: the regime for new projects (built after the introduction of new regulations) provides fixed prices (although inflation linked) for a 15-year period. The Ministry of Economy should determine each year s reference price for all of the renewable energy technologies, taking into account average capex and opex for standard projects, as well as IRR on the project. A target amount of energy produced will be auctioned off in five three-year settlement periods and only the proposed price equal or lower than the reference price for a given technology will be taken into account. Renewable energy installations will be able to sell the electricity to anyone, either bilaterally or in the market with the differences between the 26 February