MASTERS IN FINANCE EQUITY RESEARCH EDP ENERGIAS DE PORTUGAL COMPANY REPORT. Time of Changes

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1 MASTERS IN FINANCE EQUITY RESEARCH EDP ENERGIAS DE PORTUGAL ELECTRIC UTILITIES 6 JANUARY 214 ANALYST: ANA RITA MIRANDA mst16472@novasbe.pt Time of Changes Challenging Liberalized Markets As a result of EDP s privatization process, China Three Gorges (CTG) acquired a sizable position in EDP s capital structure with positive impacts on share prices (+9.53%) and financing requirements. CTG is identified as an important strategic partner that facilitates access to alternative markets and potential joint-participations in other investments. The Iberian market (MIBEL) is becoming fully integrated with lower days of market splitting in 213. This imposes more efficiency to companies in production and increases the importance of possessing the right source of production. EDP has under construction six hydro power plants with a total installed capacity of 1,697MW. Iberian activities have recently suffered due to changes in regulation, a direct result of the current economic environment in this region. Major changes include the CMEC remuneration, reduction in remuneration rates of the regulatory asset bases, and the introduction of new taxes such as the energy tax of.85% of assets. This is a segment with low future growth perspectives. EDP is currently pursuing the liberalization of its supply activity which will require significantly higher efforts from the company side given increased competition. The company will have to become more dynamic on several fronts in order to maintain its current market positioning. As the actual incumbent, EDP is regarded as having a comparative advantage over its peers. This procedure is expected to conclude in the end of 215. Brazil currently poses as a major source of future opportunities given the country s ever growing market. Demand for energy is expected to increase through the following decades (4.7% per year) in spite of the regulatory system that is currently in place. Developing economies have displayed environment concerns that have recently led to the increase in Renewables. Based on future EU targets on CO 2 reductions and EDPR expansion strategy, EDP has much to gain from this segment. Recommendation: Hold Vs Previous Recommendation HOLD Price Target FY14: 2.86 Vs Previous Price Target 2.86 Price (as of 3-Jan-14) 2.69 Reuters: EDP.LS, Bloomberg: EDP.PL 52-week range ( ) Market Cap ( m) 9,74 Outstanding Shares (m) 3,627.3 Source: EDP and Bloomberg Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Dec-13 EDP PSI2 Source: Bloomberg E 214E Revenues ( millions) 16,34 16,992 15,851 EBITDA ( millions) 3,628 3,614 3,985 Net Profit ( millions) 1, ,33 EPS (x) P/E (x) Net Debt/EBITDA (x) Debt/Assets(x) EV/EBITDA (x) ROA (x) Source: EDP and Nova Research Team Our Target price is 2.86 and the recommendation is to Hold. Company description EDP is an electric utility company founded in 1973 operating worldwide. Currently, EDP is a group of companies operating throughout the value chain of electricity. It also operates in the gas segment and in the renewable sector. It is the major electricity company in Portugal. THIS REPORT WAS PREPARED BY ANA RITA MIRANDA, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at Page 1/33

2 Table of Contents 1. COMPANY OVERVIEW... 3 COMPANY DESCRIPTION... 3 SHAREHOLDER STRUCTURE MARKET OVERVIEW... 6 ELECTRICITY IN THE WORLD AND IN EUROPE... 6 ENERGY IN THE WORLD... 7 CO 2 EMISSIONS VALUATION GENERATION IN IBERIA...11 Valuation DISTRIBUTION IN IBERIA SUPPLY IN IBERIA...18 Valuation GAS IN IBERIA...22 Valuation BRAZIL...24 Valuation RENEWABLES MULTIPLES VALUATION...28 FINANCIALS...28 APPENDIXES...28 DISCLOSURE AND DISCLAIMER...33 PAGE 2/33

3 ROE (Percent) EDP ENERGIAS DE PORTUGAL 1. Company overview Company description 15% 12% 9% 6% 3% Graph 1 - Comparables 1\ EDP RWE Endesa Iberdrol a EDPR E.ON GDF EDF % Total Assets ( billions) Source: Bloomberg. 1\ Size corresponds to market capitalization. Energias de Portugal (EDP) is a vertically integrated electric utility company that operates across multiple sectors. The company was created in 1976 from the merger of 13 public enterprises and experienced significant growth over the next decades. Although the company is smaller than most of its comparables, EDP has one of the highest return on equity (ROE) which is derived from its high leverage, much above its comparables. EDP exhibited stable return on assets (ROA) since 29 having one of the highest values among the most relevant European competitors. Inst. Capacity (MW) Table 1: Comparables' Data Net Debt/ EBITDA Net D/E EV/ EBITDA P/E P/ Book Rating (S&P) EDP % BB+ EDF % A+ RWE % BBB+ Iberdrola % BBB Endesa % BBB EDPR % N.A. Sources: Bloomberg, and NOVA Research Team. 7% 6% 5% 4% 3% 2% 1% % Graph 2: Return on Assets (Percent) EDP Iberdrola Endesa EDF EDPR RWE Source: EDP, Endesa, Iberdrola, EDF, RWE, and NOVA Research Team. The activities of EDP are split across the following sectors: Iberian electricity, Iberian natural gas, Brazil, and Renewables. Since many of these activities are capital intensive (e.g.: electricity production and distribution), EDP is largely affected by regulation and is under the scrutiny of ERSE 1. The electricity sector is comprised by electricity production, distribution, and supply (commercialization). Production is carried out in two different regimes: conventional regime with installed capacity of 13,343 MW, and special regime with installed capacity of 466 MW. The special regime (PRE) has priority dispatch in the electricity markets and it was developed due to the finite character of fossil fuels and the need to diversify energy sources. This regime currently includes mini-hydroelectric 2, cogeneration, and biomass and residuals production. For the purpose of this report, the production segment is valued by differentiating the production from regulated and from liberalized production. The share of hydro and wind s installed capacity has increased, while thermal and combined cycle maintained a stable share of installed capacity. Regarding the 1 Entidade Reguladora dos Serviços Energéticos (ERSE) is the Portuguese supervisor for energy services (electricity and gas). 2 Hydroelectric power plants with an installed capacity below 1MW. PAGE 3/33

4 1% 8% 6% 4% 2% % -2% E 214E Reg. Production Lib. Production Distribution Supply Gas Brazil Renewables Other and Adjustments 5% 4% 3% 2% 1% % Graph 4: Turnover Breakdown (Percent) Graph 5: EBITDA Breakdown (Percent) 1% 8% 6% 4% 2% % -2% E 214E Reg. Production Lib. Production Distribution Supply Gas Brazil Renewables Other and Adjustments Graph 6: Iberian Market Shares (Percent) 13% 9% Electricity Supply - Market Leader Electricity Supply - EDP Gas Supply - Market Leader Gas Supply - EDP net production, wind has doubled its weight in total production, while the combined cycle has decreased exponentially. EDP s distribution of electricity is performed in high, medium, and low voltage and it consist in a large network that covers 223,734 Km in Portugal and 22,986 Km in Spain. Given that these networks imply large investments in fixed assets, the activity is capital intensive and is classified as a natural monopoly that requires the intervention of regulatory institutions in order to establish the remuneration in the segment. The supply activity consists in the commercialization of electricity and it was originally fully regulated. With the liberalization of the market, the relative size of regulated and last resort supply (LRS) activities compared to total EDP s supply has steadily decreased and it currently accounts for 67% of commercialization in Portugal and 4% in Spain. EDP s commercialized a total of 29,63 GWh 3 in Portugal and 2,252 GWh in Spain, denoting a much larger presence in the Portuguese market given the differences in each country's size and population. The natural gas sector includes storage, distribution and supply with operations in Portugal and Spain. EDP, which is the second largest operator in both markets, can either sell the gas or use it to produce electricity in its CCGT plants. In 212 EDP supplied more than one million consumers, counted with 14,196 km of distribution grid and commercialized more than 35 TWh. Similarly to the Iberian activities, the Brazilian sector also incorporates production, distribution and supply of electricity. Production is mostly focused on the conventional regime and installed capacity amounted to 1,974 MW in 212. Distribution is performed through EDP Bandeirante and EDP Escelsa, and it is characterized by a network extension of 85,749 Km. Supply of electricity in Brazil consisted in 24,923 GWh during 212 where 63% was regulated. Renewables, operated by EDP Renováveis (EDPR), comprises mainly the wind generation and amounted to a total of 8,145 MW of installed capacity, being present in Europe, north and south of the American continent. In 212, EDPR produced 18,445 GWh which were entirely sold due to its priority in dispatch while subject to feed-in-tariffs 4. Shareholder Structure EDP currently possess a total of 3,656.5 million shares, all of them class A shares 5 with nominal value of one euro and fully paid. Its shareholder structure has changed over time mainly through its reprivatization process that began in 3 One Gigawatt hours (GWh) is equivalent to one million kilowatt hours (KWh). One KWh is the output of a power station with an installed capacity of 1KW operating during one hour at its full capacity. 4 Tariff/price entitled to renewables technologies in order to encourage investment in these types of technology. 5 Until recently, there were also class B shares which were the ones to be reprivatized. PAGE 4/33

5 Iberdrola EDPR EDF RWE Fersa Energias Renovables EDP ENERGIAS DE PORTUGAL Graph 7: EDPB and Brazilian Market (Percent) 1.55% 2.47% Net Net Generation Consumption (TWh) (TWh) Brazil 1.74% Installed Capacity (GW) % EDPB 3.% 2.% 1.%.% Sources: EDP, World Bank, and NOVA Research Team Graph 8: Wind Installed Capacity (GW) 7.99 Sources: EDP, Iberdrola, EDF, RWE, Fersa Energias Renovables, and NOVA Research Team. Table 2: Shareholders' Structure SHAREHOLDERS % Capital China Three Gorges 21.4% Oppidum 7.2% Iberdrola Energia S.A.U. 6.7% Capital Group Companies, Inc. 5.% José de Mello Energia, S.A. 4.6% SENFORA SARL 4.% Grupo BCP; FP do Grupo BCP 3.4% Sonatrach 2.4% Qatar Holding LLC 2.3% Massachusetts Financial Services Company 2.2% BlackRock, Inc. 2.% Banco Espírito Santo, S.A..3% EDP (Treasury Stock).8% Free Float 38.5% Total 1.% June This process has been characterized by 8 stages where the most recent and relevant one occurred in October 211 in which shares detained by Parpública 6, a public holding that owned golden-shares at EDP 7, were sold in two phases. The first phase included a sale of 21.35% of capital which was acquired by China Three Gorges (CTG), a Chinese government owned company operating in the energy sector with an installed capacity of 74.8GW. This transaction amounted to 2.7 billion that represents a price per share of 3.45 and a premium of 53% 8, with a positive impact on market share prices of.22 (+9.53%) through the following two weeks 9.CTG s entry into the company s capital is perceived positively given the significant share price appreciation that has been observed since the transaction. For instance, during the last two years EDP s stock price has increased by 23.86%, amounting to 11.29% per year. The second phase took place in February 213 where the remaining Parpublica s stake of 4.14% was sold as free float given that an agreement with CTG was not achieved. This stake was sold at a price of 2.35 per share, which represented a discount of 2.97% compared to the previous day s closing price. After the sale EDP s shares experienced a decline of 8% that took approximately one month to recover from. CTG s strategy lies in renewable energies and aims, with the investment in EDP, to become a strategic partner in this field. This led to its current agreement that includes a 4 year lock-up and standstill period by CTG which, in addition to a granted credit facility of 2 billion for a maturity of 2 years, contributed to stabilize the shareholder structure and improve EDP s liquidity position which is very important due to the recent financing restrictions that Portuguese corporations have experienced. In 211 it was estimated that EDP needed refinancing of about 2.6 billion per year during three years 1. Furthermore, 211 s annual accounts also indicated debt repayments of 3. billion in 212, and 2.7 billion in 213. This entire standing improved due to CTG s entry and current EDP estimates suggest that no more refinancing will be required until the end of 214. EDP is presently pursuing a deleveraging strategy and aims to achieve the target of three times the debt-to-ebitda ratio by 215. The agreement has also settled the purchase of minority stakes by CTG in the renewable sector. This gives EDP 6 DL 16-A/211, from October 26 th, in which the disinvestment of Parpublica in EDP has been authorized. 7 Golden shares gave the right of veto regarding some matters. 8 According to recent news, this premium was based on expected standstill regulatory environment. 9 Increase from 22 of December 211, when the purchasing was agreed, until 2 of January Financial Times. PAGE 5/33

6 Thousands Thousands EDP ENERGIAS DE PORTUGAL the opportunity to become more active in the upside potential of the growing Chinese market as well as a joint-participation in other investments as are the ones recently announced in Africa and Brazil Source: EIA Non-OECD OECD Source: EIA. Chart 9: Installed Capacity by Region/Country (Gigawatthour) 2. Market Overview Electricity in the World and in Europe World s installed capacity is expected to grow at an average rate of 1.6% per year from 21 until 24 but with significantly different growth rates across regions. OECD countries are expected to grow at an average of.9% per year, while non-oecd countries are expected to grow at 2.3% on average, with Brazil and China in the leading positions. This denotes a clear discrepancy between developed and developing or emerging economies. In absolute values OECD countries remain fairly stable in regards to total installed capacity, whereas non OECD greatly increase their share and China alone represents 27.4% of world s total installed capacity in US OECD Europe Other OECD China Brazil Africa Other Non-OECD Chart 11: World Energy Demand (Quadrillion Btu) Regarding the world s total generation of electricity it is forecasted to increase by an average of 2.2% per year from 212 to 24, which is slower than the preceding 7 years in which the average rate was 3.1%. This implies a change in the sources shares over time. For instance, coal is forecasted to lose 4 percentage points between 212 and 24 whereas renewable sources increase from 19% to 25% and natural gas from 2% to 24%. 11 Recent articles on newspapers (e.g.: Jornal de Negócios). 12 We used net generation as a proxy for demand. Non- OECD OECD % 2% 15% 4% Chart 1: Electricity Generation by Fuel (' TWh) World Demand 12 exhibits an expected growth rate of 2.2% from 21 until 24 but with differences across regions. OECD countries present an average growth rate of 1.1%, with US and OECD Europe both under the average with.8% and % 23% 11% 39% % 21% 13% 38% % 4% 3% 2% Oil and other liquids Coal Nuclear Natural gas Hydro Wind Solar Other Source: EIA. 5% 16% 24% 14% 36% PAGE 6/33

7 Thousands EDP ENERGIAS DE PORTUGAL Source: EIA Chart 12: Net generation by Region/Country (Billion KWh) US Other OECD Brazil Source: EIA. Chart 13: World Coal Consumption (Quadrillion Btu) Source: EIA. Chart 14: Henry Hub Natural Gas Spot Prices (USD/MMbtu) Source: Bloomberg. OECD Europe China Africa Chart 15: World Natural Gas Consumption (Trillion cubic feet) 1.%, respectively. Non-OECD countries present an expected growth rate of 3.1% with China above average (3.7%) and Brazil and Africa both with 3.% growth rates. Energy in the World World s consumption of energy, which encompasses natural gas, coal, oil, nuclear and others, presents the same trend. Non-OECD countries exhibit exponential grow while developed countries experience a more moderate growth. Coal Coal consumption is expected to increase by an average of 1.3% although the increase is driven by developing countries, mainly in Central and South America and Asia. Developing countries are expected to decrease its consumption. Coal used for electricity generation is expected to decrease its proportion in total generation while increasing its absolute value which implies a significantly higher growth for alternative inputs. On a side note, coal prices are expected to grow at an average rate of 3%, according to the U.S. Energy Information Administration outlook (EIA). Natural Gas Total natural gas consumption is expected to increase by an average rate of 1.3% per year, again driven by developing countries. Some of the natural gas consumption will be in production of electricity, which is expected to increase both in total share of generation and absolute value. As a fossil fuel natural gas reserves are claimed to be finite and we will eventually become unable to extract it. Nevertheless, technological advancements, new transformation processes, and even the appearance of new theories suggest that these inputs are not as finite as it was believed. Natural gas consumption in electricity production will also depend on its relative price to other energy sources. Its price has been decreasing remaining at low levels but it is expected to increase at 3.4% yearly average until Nuclear 8 Nuclear consumption is expected to experience a high increase (2.5% average 6 per year) for which the major contributors are China, Europe and America, with a 4 combined consumption of 62% of total consumption in Nuclear plants are on average one of the most efficient forms of production with low marginal costs of production. Nevertheless, it is a very capital intensive type Source: EIA. 13 EIA, Annual Energy Outlook (AEO), 213. PAGE 7/33

8 6, 5, 4, 3, 2, Source: EIA Chart 16: World Nuclear Consumption (Billion KWh) Chart 17: Implied GHG emissions from electricity generation (CO2/KWh) Coal Gas oil Fuel Oil Natural Gas Source: CO 2 emissions from fuel combustion, 212 Edition, IEA. Sum of the Parts approach, valuing each business separately. of production with some environmental concerns, mainly after the incident in Fukushima, Japan. CO 2 emissions Concerns about the environment have been growing around the world, which has implications on the decision of each source of energy to use. The European Union (EU) has established targets for 22 currently called , in which the ambition is to reduce by 2% greenhouse gas emissions (versus 199), to increase to 2% consumption of renewable sources, and to reduce by 2% the use of primary energy (versus 27). The EU is also committed to a low-carbon economy and until 25 aims to reduce greenhouse gas emissions to 2% of 199 levels 15. This might have implications in the CO2 prices and consequently in the decisions of the companies in regards to energy source selections and investment valuations. 3. Valuation The valuation of the company is done through a Sum of the Parts approach where each business is valued separately. A Discounted Cash flow model is applied for each segment where the Free Cash Flow (FCF) is discounted at the Weighted Average Cost of Capital (WACC), a measure that captures each business risk. To compute the WACC there are three major terms to be considered: the cost of debt, the cost of equity and the target debt-to-equity ratio. In regards to the cost of debt, EDP can finance itself as a whole which offers better conditions than separate financing for each business unit. Therefore, the cost of debt was computed for the whole company and considered equal across units. Nevertheless, in order to reduce exchange rate risk the company borrows in local currencies (e.g.: euros, Brazilian reais and US dollars). This cost was computed using two different approaches. The first approach determines the cost of debt by adding the risk free rate to a spread based on the rating of the company. EDP s rating is currently BB+ which corresponds to a spread of 3.% 16. For the risk free we have considered an 14 European Directive /EU. 15 This vision incorporates intermediate milestone goals of 6% by 23 and 4% by Data collected by Aswath Damodaran, a Professor of Finance in Stern School of Business at New York University. PAGE 8/33

9 Table 3: Default Spread Spread A 1.% A- 1.3% BBB 2.% BB+ 3.% BB 4.% B+ 5.% Source: Damodaran. Cost of Debt using EDP s 1y yield, probability of default and recovery rates. historical average of the 1 year German bond for the Iberian activities (2.36%). These computations provide a cost of debt of 5.36%. For the particular case of Brazil where activities are accounted in Brazilian reais the risk free was determined using the covered interest rate parity 17, with the 1 year German bond, the current exchange rate, and the 5 year forward exchange rate. We have also looked at the inflation rate differential between these two countries. For this valuation, the risk free rate for Brazil is considered 4.96%. The second approach takes into account EDP s current 1 year yield from a zero coupon bond, along with the historical probability of default and recovery rates of companies with similar ratings 18. EDP s 1 year yield currently stands at 4.47%, and the probability of default and the recovery rates of BB+ rated companies correspond to 1.51% and 7.7%, respectively. This computation provided a cost of debt of 4.82%. For the purpose of the valuation we shall rely on the second approach as it is more detailed. Even though the risk free rate is considered to be different in Brazil, the cost of debt will be considered the same as we are using the method based on market yields and default rates. Cost of Equity determined using comparables and segment s unlevered betas Since we utilize a sum of the parts approach, the cost of equity was determined with the intent of valuing each segment separately. The basis of our approach lies on CAPM 19. However, since company returns only yield aggregated results, we rely on comparables to assess the systematic risk of each activity. This is not a straightforward task as the majority of companies do not operate in one single business. Therefore, we define comparables as companies that, while still possessing activities throughout the entire value chain, tend to emphasize a particular segment, while having a similar size, and rating 2. We can find in the Appendix 2 more details on this selection ( ) where stands for the domestic interest rate and for the foreign interest rate., where corresponds to the market yield of a 1y zero coupon bond, to the probability of default of BB+ rated companies, and to the recovery rate of BB+ rated companies. Moody s Investors Service. February 29. Corporate Default and Recovery Rates, Standard&Poors. March 211. Default, Transition, and Recovery: 21 Annual Global Corporate Default Study and Rating Transitions. 19 Capital Asset Pricing Model (CAPM), used to compute the expected return of the asset using the following equation: ( ) to estimate the parameters. This methodology only takes into account the systematic component of risk as investors are capable of diversifying the firm specific risk. We used ( ) where CRP stands for the country risk premium. 2 In Principles of implementation and best practice for WACC calculation, Independent regulators Group, 27 PAGE 9/33

10 For each segment we have estimated the unlevered beta through the average of comparables which was later relevered 21 through the market debt-to-equity ratio. Current market debt-to-equity ratio was determined at 2.1. Nevertheless, the target lies below this number as EDP is pursuing a deleveraging strategy with a target ratio of 2.. Country risk premium computed using Credit default swaps Market risk premium is assumed to be in accordance with literature. Country risk premium (CRP) was computed using Credit default swaps (CDS) and the relative weight of standard deviation of equities and bonds in the local market. We have also looked at local and global market variances to have a better sense of the value for CRP 23. For the perpetuity we used the NOPLAT of the last year of the explicit period, the growth rate for each economy, and the perpetuity formula 24. Long term growth rates using IMF projections For the growth rate, we have considered an inflation rate of 2% for Europe, consistent with European Central Bank s long-term strategy 25 and for Brazil an inflation rate of 4.5%, which is consistent with the International Monetary Fund s (IMF) projections for medium term and also according to Brazilian s Central Bank target for inflation 26. For the real growth rate we have looked at the projected real GDP growth of the IMF, where we identify long-term growth of 1.8% in Portugal, 1.2% in Spain and 3.5% in Brazil. Beta Unlevered Target D/E 2. Nominal growth rate (g) Country Risk Premium (CRP) Marginal Tax Rate Rd 4.82% Portugal 3.% Portugal 3.25% Portugal 29.5% rf ( ) 2.36% Spain 3.% Spain 3.1% Spain 3.% rf (br) 4.96% Brazil 5.% Brazil 4.82% Brazil 34.% Regulated production Liberalised Production Distribution Portugal Table 4: Valuation Inputs Valuation Distribution Spain WACC Supply Portugal Supply Spain Gas Brazil Re 11.4% 12.5% 11.4% 11.3% 14.% 13.8% 14.9% 18.1% WACC 6.6% 6.43% 6.8% 6.1% 6.93% 6.85% 7.21% 8.15% 21 * +, although the implicit is not equal to zero, we currently face a situation where the risk free rate is significantly below its historical value. This leads to an exaggeration in computations. 22 Market Risk Premium and Risk Free Rate used for 51 countries in 213, 213, Pablo Fernandez, Javier Aguirreamalloa and Pablo Linares. d as being the most probable value for market risk premium. 23 Systematic Country Risk Modulator in Practical Approach for Quantifying Country Risk, Jaime Sabal, ESADE. 24 To compute the perpetuity value we used: ( ), Valuation, McKinsey &Company, Tim Koller, Marc Goedhart, Daviv Wessels, p According to the IMF, until 218 it is expected an average inflation rate of 1.4% for Portugal and 1.5% for Spain, but we have considered the long term expectations for the euro area. 26 Recent inflation rates in this country have been historically high, registering in 212 an inflation of 5.84% (according to the Brazil Central Bank). PAGE 1/33

11 4. Generation in Iberia Long term growth rates using IMF projections Graph 17: Mibel statistics 6% 5% 4% 3% 2% 1% % Market Price Spread (Pt-SP) % of Market Split Source: Ren. Portugal and Spain started to build an integrated market and since July 26 the Iberian market for electricity (MIBEL) is functioning. MIBEL works based on two parts: OMIP in Portugal and OMEL in Spain, where OMIP supervises the forward/future market and OMEL operates the daily and intra-day market (spot market). The participants are Spanish and Portuguese companies and the price is equal across the pool. Although MIBEL aimed to be a fully integrated market there is operational problems in terms or connections between these two countries. Currently, the capacity of the connection is 16MW from Spain- Portugal and 13MW from Portugal-Spain, with the goal of increasing it to 3MW in both directions by 214. A major problem with these connections is that they often become congested, which causes a market split and two distinct markets with differentiated prices arise. In 213 there were 5.3% of days where the price was not different, 31.9% where the price in Spain was higher than in Portugal and 17.8% where the price in Portugal was higher than in Spain 27. Over time the market became more integrated as shown by the diminishing of market split days and the decrease in market prices across the two countries. In addition, there are issues related to regulated production that is not included in supply which distorts the price obtained there. Nevertheless, in what concerns production, the relevant market is Iberia 28. The production of electricity can be done in two regimes: ordinary regime of production (PRO) and PRE, where PRE includes mini-hydro, cogeneration, biomass and waste and PRO includes all the other forms of production. Aside from the requisites necessary to be classified as PRE, this production has priority in selling. In Portugal, the LRS, operated by EDP Universal, S.A. is obliged to buy all this production 29. In Spain, the system is similar but all the PRE production is fully absorbed. PRE price is pre-determined by law, and even though PRE production can be sold to someone other than the LRS, there is a floor and a maximum to pay to these producers. In 212, EDP registered a production in Portugal of 17,17GWh from 9.927MW of installed capacity. Regarding Spain, the total production was 1,8GWh with 3,882MW of installed capacity. As of December 212, PRE installed capacity in Iberia totalled 466 MW which represents 3.4% of total capacity, and 2,247 GWh of production, representing 8% of total production. In addition to the split of PRO 27 Source: OMIE, data until mid-december. In 212 the numbers were: 68.5%, % and 41.5%, respectively. 28 Regarding supply, the two markets will be considered separately as each country has its own specificities and different correlations to the key value drivers. 29 According to Decree-Law which establishes the duties of the Last Resort Supplier. PAGE 11/33

12 Table 5: Power Plants under PPA/CMEC End of PPA Thermal Plants Installed Capacity (MW) Sines (coal) End of PPA Hydro Plants Installed Capacity (MW) Plants Plants Plant Plant Plants Plant Source: EDP and Research Analyst Table 6: Installed Capacity in Construction (MW) MW Start date Ribeiradio 81 2H 214 Foz do Tua 252 2H 216 Baixo Sabor 173 2H 214 Venda Nova III (repowering) 746 2H 215 Salamonde II (repowering) 27 2H 216 Fridão Source: EDP Hydro Plants and PRE production, we also have a special situation in Portugal, where some of the PRO production is remunerated under CMEC compensations (costs with the maintenance of contractual equilibrium, the old PPA power purchase agreement with a real pre-tax return on assets of 8.5%) and market conditions production. CMEC compensation, which has been legally defined by DL 24/24, is in place for 26 power plants with a total installed capacity of 5,287MW and will last until 227. The transition of CMECs to liberalized conditions will have significant developments in 213 and 215 where 27% of the installed capacity will switch, and 224 where 42% will also shift. Other years only have residual transitions to the liberalized status. The CMEC scheme comprises two periods. The first period will be in place until 217 in which EDP operates in the free market but its remuneration is predetermined 3, that is, EDP receives the market price from the Iberian pool but has to compensate the government if revenues under CMEC are below (has to pay the government) or above (has to receive from the government) market revenues. From 217 on, there will be no more compensation with the government and the risk is fully absorbed by EDP. The CMEC formula relies on a fixed amount per year plus a parcel with three components that are often revised 31. The CMEC base the difference between NPV of PPA and NPV of CMEC is currently at.8billion and it has been revised downwards in about 13 million 32 of annual revenues as agreed in the Memorandum of Understanding (MoU) between the Portuguese authorities and the IMF. This was achieved through a change in the rate of tariff repercussion for contractual balance 33. Therefore, although we expect stable FCFs, we need to anticipate potential changes such as the ones introduced by the financial assistance program. The mix of production is 34% hydro, 33% wind, 17% CCGT and 16% from other sources, where clean production is clearly the major source of production, amounting to 67% of total production. EDP s strategy is to increase the share of clean production to 73% by 215, for which it will contribute the already in construction six hydro power plants that shall be commissioned in These plants imply a total investment of 2 billion. 3 Remuneration is predetermined in order to decrease market imperfections. If the supply is in the free market, even though the company does not receive the market price, it will be determined as if the company is offering in the market. 31 Availability of power plants, market gross margin adjustment, and power services revenues. 32 The value is an estimation of reduction per year which, according to EDP has a PV of 12 million. The reduction will be in place until Portaria 145/212. PAGE 12/33

13 Thousands EDP ENERGIAS DE PORTUGAL 6% 4% 2% % 4% 3% 2% 1% Graph 18 - Gross Production Evolution - Forecast (GWh) PT demand Total Demand Source: NOVA Research Analyst SP demand Graph 19: Thermal - Implied Load factors EDP Iberdrola Endesa Sources: EDP, Iberdrola, Endesa, and NOVA Research Analyst Graph 2: Hydro - Implied Load factors % EDP Iberdrola Endesa Sources: EDP, Iberdrola, Endesa, and NOVA Research Analyst 1% 8% 6% 4% 2% % Graph 21: Nuclear - Implied Load factors EDP Iberdrola Endesa Sources: EDP, Iberdrola, Endesa, and NOVA Research Analyst Valuation The key value drivers for production activity are evolution of demand, remuneration of regulated production, PRE output, load factors and price in the Iberian pool. Production evolution is very close to demand evolution, which in turn is tied to GDP variations, population evolution and economy development. For the purpose of our analysis the demand evolution was forecasted using GDP growth as the other variables were not statistically significant 34. According to our estimations total production will increase at a slower pace, from 351,79 GWh in 212 to 374,861 GWh in 218, which is equivalent to an average increase of 1.1%. After the estimation of production the company needs to analyze the technology with the lowest variable costs to produce so that it can send selling bids to the market in order to reach the Iberian pool market price. For that, the company needs to estimate the amount of production from each technology according to power plants loads factors 35 and the marginal cost per each unit of production. Regarding Load factors we can see that EDP s implied load factors significantly vary depending on the source. When compared to its peers, EDP faces higher load factors on hydro production, similar load factors on nuclear production and lower load factors on thermal production. Nevertheless, we must be cautious when evaluating load factors given the sizable amount of clean sources of production in EDP. These clean sources not only have priority in the grid, but they also have the lowest marginal costs of production. As a result, they are intensively used with efficiently determined load factors. Opposite to this thermal plants will only be used when other sources cannot fully sustain demand and the resulting load factors will be much lower than what they could potentially be. The analysis is different when the decision concerns the type of technology to build. For this case we must look at the levelized cost of energy (LCoE) which gives us the average unit cost per MWh of a payment stream that has the same present value as the total cost of building and operating a generating plant over its life 36. This measure gives us the possibility to rank technologies according to cost, which has implications in the decisions for investment For more detailed information see Supply valuation. 35 Load factor is the percentage of use of a plant, or in other words, what is the real production compared to the maximum potential. Load factors are calculated as:. 36 Levelized Cost of Energy Calculation Methodology and Sensitivity, Black & Veatch report 37 Electricity Generation Costs, from Department of Energy & Climate Change from October 212. PAGE 13/33

14 Coal-fired gas-fired nuclear wind mini-hydro solar combined heat and power Coal-fired gas-fired nuclear wind mini-hydro solar combined heat and power EDP ENERGIAS DE PORTUGAL Graph 22: LCoE at 5% Discount rate However, it is important to note that these estimations are highly sensitive to its parameters and the evolution of prices (fuel inputs). As such, it is not surprising that gas production in the USA has increased as natural gas prices have decreased. Alternatively, coal is the input that is most sensitive to changes in CO 2 costs, followed by gas and coal technology with carbon capture and storage. Therefore the decision of what technology to put at work changes over times as parameters changes. Source: EIA minimum maximum Graph 23: LCoE at 1% Discount rate Minimum Source: EIA. 1% 8% 6% 4% 2% Maximum Graph 24: EDP's Capex 213 (billion ) %.7 3 Maintenance Wind Hydro Brazil Graph 25: Electricity Production (Percent) According to ERSE from 28 until July 212, the electricity placed in the grid comprised a large share from PRE followed by nuclear and then hydro 38. Some plants are entitled to receive capacity payments that are payments to compensate the cost of building the plants that work as a backup. As an example, CCGT capacity payment has been revised downwards to 6,/MW from 214 onwards. We also believe that CO 2 prices will increase as the legislation will become more restrictive and as European directives and objectives of are put in place. CAPEX is expected to be at 1.6 billion per year from 213 to 215 with marginal increases afterwards. EDP might have a competitive advantage since it has the largest part of hydro production and is thus not affected by CO 2 prices. CAPEX will mostly comprise maintenance and investments in power plants in order to respond to the small increases in demand. According to Resolução de Ministros 2/213 from April 213 we expect to increase hydro power to 8536MW until 22. Regarding nuclear plants, after the Fukushima disaster in 211, Spain announced the closing of a nuclear plant. However, recent events show more indecision about the closing which might indicate that nuclear will not be extinguished. Perhaps, the cost will increase by increasing safety obligations in the plants. Recently a new tax on production and distribution of electricity and gas has been created, amounting to a total of.85% of fixed assets. This was created in the context of the financial assistance program. EDP Iberdrola Endesa Hydro Thermal Nuclear Other Sources: EDP, Iberdrola, and Endesa. 38 Tarifas e preços para a energa eléctrica e outros serviços em 213, from ERSE december 212. PAGE 14/33

15 Table 6: Regulated Production Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT Depreciation and Amortization (1) Other Adjustments (2) (1) 163 (2) (2) (2) (2) (2) (2) Cash Flow from Operations CAPEX (81) (95) (19) 89 (165) 623 (158) 1,367 Operating NWC 11 (61) (5) 13 (15) 137 Other LT Operating Assets and Liabilities (214) (9) (12) 11 Cash Flow from Investing Activities (195) (247) (6) 1,36 (15) 678 (185) 1,614 FCF , , ,835 PV FCF 4,687 t 29.5% Terminal value (PV)* 2,253 g 3.% Value Regulated Production 6,94.59 per share WACC 6.6% (1),(2): See Appendix 1 *until 227 Table 7: Liberalized Production in Iberia Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT Depreciation and Amortization Other Adjustments (3) 7 (8) (1) (11) (11) (12) (12) Cash Flow from Operations CAPEX (62) (291) (396) (8) (786) (614) (639) (649) Operating NWC (8) (3) (49) (7) (7) (3) Other LT Operating Assets and Liabilities (18) (8) (12) (24) (3) (16) Cash Flow from Investing Activities (717) (31) (457) (831) (748) (588) (593) (668) FCF (717) (31) (457) (831) (748) (588) (593) (668) PV FCF (584) Terminal value (PV) 4,468 g 3.% Value Liberalized Production 3, per share WACC 6.43% 5. Distribution in Iberia The next units in the value chain are Transmission and Distribution, which Portuguese Regulator: ERSE. Spanish Regulator: CNE. Regulatory periods. correspond to activities of transportation of the electricity from the production sites to consumers. Transmission is related to higher voltage networks and distribution to lower voltage ones. These two activities are considered natural monopolies, therefore they are regulated and concessions are given to companies. As a regulated activity, tariffs are determined by the supervisor - ERSE in Portugal and CNE 39 in Spain and regulatory periods are determined. Distribution in Portugal is characterized by a network of 223,734 km, which has grown at an average of 1.2% since 29 that disseminated, in gross terms, 48,559 GWh during the year of 212. The distribution losses registered an average of 7.2% from 28 to 212, which is in line with EIA statistics that have estimated for the USA an average of losses of about 7%. EDP operates in high, 39 Comisión Nacional de Energía (CNE) is the Spanish supervisor for energy services. PAGE 15/33

16 medium and low voltage networks 4. The first two types of network concessions are attributed by government while low voltage concessions are agreed between the company and municipalities. Stable revenues is a characteristic. Remuneration based on Regulatory Asset Base (RAB). In Portugal is indexed to Portuguese 5y CDS Chart 26: EDP's Operational Costs in Distribution 1\ Allowed Costs Source: ERSE. 1\ 211 Constant prices. EDP Real Costs As a regulated activity, this segment is characterized by stable revenues and costs. The Iberian economy has faced a turbulent period during the last five years. Nevertheless, this segment s EBITDA remained steady, amounting to 17.5% of total EBITDA. Still, the activity is subject to the interference of regulatory actions which may take several forms. We currently stand in the middle of a regulatory period 41 and parameters and formulas were established in order to determine the Regulatory Asset Base (RAB), constituting the value base by which companies are remunerated. The Return on RAB (RRAB) is determined by the regulator and uses the WACC methodology, reporting nominal pre-tax remuneration rate. The WACC methodology is used by several regulators, with slight changes in the reporting values. In hopes of comparing regulatory approaches, ERSE compared WACC methodologies across 21 and confirmed that differences are minimal 42. Allowed revenues for 214 are 3.49 billion and the RRAB is indexed to the Portuguese 5y CDS 43 from October in year t-1 to September year t, subject to a floor of 8% and cap of 11% 44. The average until September 213 was 37 basis points which have been decreasing since the beginning of the regulatory period leading to a RRAB of 8.56% (comparable to 1.5% in 212). ERSE has defined an efficient factor for operational costs and incremental grid costs of 3.5%. Additionally, there is an incentive to reduce losses in distribution. The Spanish market amounted to a total of GWh in 212, which has varied significantly since 28 with an annual average decrease of 2% where EDP, through HC Distribución, operated km and managed in gross terms GWh in 212. This implies that EDP s market share was 3.9% in 212, having remained stable since 28 where it was closer to 4%. EBITDA also remained stable during these years, amounting to 5% of total EBITDA. Note that losses in the system averaged 3.7% in the latest years which is lower than the Spanish average of 8% 45. Real Decreto 222/28, 15 th of February established the remuneration methodology of the distribution activity in Spain, after RDL 2819/1998, 23 rd of 4 These concessions are attributed according to several Decree-Laws, namely DL29/26 and DL 344-B/82, among others. 41 Regulatory periods last three years. The current one ranges from 212 to Parâmetros de Regulação para o período 212 a 214, from ERSE, December In the previous regulatory period it was indexed to 1y bonds. 44 Which corresponds to.8% and 14.8% CDS average for floor and cap, respectively. 45 World Bank statistics for 29, 21 and 211. PAGE 16/33

17 Remuneration in Spain is linked to 1y government bond plus a 2 basis points spread Measures to reduce the Tariff Deficit in Spain December, which regulates the activity through the net RAB. According to RD 9/213, the remuneration is linked to the 1y government bond plus a spread of 2 basis points and a lag of two years. The remuneration for each company is published every year in Boletín Oficial del Estado (BOE). For 213 the remuneration of HC Distribución is of 15 million (IET/221/213, 14th of February). Spain has tried through a serial of laws to contain the problem of the tariff deficit 46, which has reached 26 billion. For instance, the RDL 2/213 attempted to adopt measures to correct the deviation from revenues and costs to regulated prices, while also changing the rule to update allowed costs. In addition, RDL 9/213 established new taxes to energy production. Based in all of these changes future regulatory actions are expected Chart 27: CDS 5y (Basis points) Valuation For 213 the RRAB was established in 8.56% but we expect a decrease since CDS have been decreasing and exhibited an average in the last quarter of 213 of 36 basis points with a tendency towards 8%. This remuneration currently exceeds our computed WACC since we differentiated in our approach and many of the inputs that the regulators utilized surpassed our figures. Since the remuneration rate exceeds the discount rate, the fair value of the regulated assets exceeds the RAB. Portugal Greece USA Source: Bloomberg. Ireland Spain According to ERSE the costs with grid connections range from 7.2 to 23.1 for aerial connections and from to for underground connections. As we are in a mature market, new connections opportunities are diminishing 47. The expenditures are mainly in maintenance CAPEX. Table 8: Distribution in Portugal Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT (127) Depreciation and Amortization Other Adjustments 7 88 (2) (2) (2) (2) (2) (2) Cash Flow from Operations CAPEX (187) (542) (259) (31) (315) (331) (35) (371) Operating NWC 17 (415) (1) (16) Other LT Operating Assets and Liabilities (324) (324) (27) (8) Cash Flow from Investing Activities (44) (1,281) (296) (256) (183) (32) (271) (315) FCF 147 (651) (155) PV FCF 1,61 t 29.5% Terminal value (PV) 4,897 g 3.% Value Distribution Portugal 5, per share WACC 6.8% 46 The accumulated amount of costs are not reflected in the price paid by consumers which has to be repaid to companies at some point. 47 According to ERSE and EDP Distribuição the number of new connections have been decreasing since 28. PAGE 17/33

18 Thousands Millions EDP ENERGIAS DE PORTUGAL Table 9: Distribution in Spain Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT Depreciation and Amortization Other Adjustments (7) 24 Cash Flow from Operations CAPEX (95) (35) (38) (39) (44) (47) (49) (54) Operating NWC 12 (3) 2 1 (1) 1 1 Other LT Operating Assets and Liabilities (8) (6) (3) () (1) 1 (1) 1 Cash Flow from Investing Activities (91) (44) (39) (39) (45) (47) (49) (51) FCF PV FCF 274 t 3.% Terminal value (PV) 765 g 3.% Value Distribution Spain 1,39.9 per share WACC 6.1% 6. Supply in Iberia Graph 28: EDP's number of consumers in Portugal LRS Liberalised Chart 29: EDP's Supplied Electricity in Portugal (GWh) LRS Liberalised The supply activity consists in the service of providing energy to consumers from the moment the electricity goes out of the grid to the moment it reaches houses and other facilities. This activity is not capital intensive as its major investments include electricity measuring devices, marketing and physical facilities to inform consumers. EDP supplies electricity in Portugal and Spain through two regimes: liberalized supply and regulated or last resort supply (LRS), where the latter is operated by EDP Serviço Universal in Portugal and HC Energía in Spain. Currently, EDP is the major liberalized supplier in Portugal with a market share of 44% which increased from 4.1% last year 48. Other companies in Portugal include Endesa and Iberdrola. In regards to the Spanish market, Endesa, Iberdrola and GNF hold the leading positions and EDP ranks in fourth place 49. Overall, this implies that EDP is number three in the entire Iberian market, behind Endesa and Iberdrola 5. Concerning Portugal, as of December 212 EDP had 6.6 million consumers (87% LRS) and supplied a total of 29,62 GWh (67% LRS). Those large percentages are explained by the process of liberalization which is reaching its final stage. The liberalization has two different paths to differentiate large consumers (the ones with contracted power capacity equal or above 1.35KvA 51 ) from small consumers. The transitory period for the large consumers started in July 212, and it will last until the end of 214, demarking the termination of the transitory tariffs established by ERSE. The small consumers only began the 48 ERSE, Resumo Informativo Mercado Liberalizado Eletricidade, August CNE, Informe de Supervisión del mercado minorista de electricidad, junio EDP s share regarding regulated supply was 31% and regarding liberalized supply 13%, as of December KvA= 1, volt amperes, which is a unit of apparent power, where an ampere measures electrical current and volt measures the electrical potential. PAGE 18/33

19 Thousands Thousands Thousands EDP ENERGIAS DE PORTUGAL 75% 5% 25% % 1, Graph 3: EDP's Market 8.3% Share 64.9% (Percent) 51.% 41.6% 39.5% % 11.1% 11.4% 1.5% Portugal Spain Graph 31: EDP's number of consumers in Spain LRS Liberalised 2 1 Graph 32: EDP's Supplied Electricity in Spain (GWh) LRS Liberalised Graph 33: EDP's expected sales in Portugal (GWh) LRS Liberalised transitory period in January 213 which will have effect until 215. By 216 all consumers have to be supplied by a liberalized provider. During the transitory period ERSE updates tariffs every three months and applies a penalty to encourage the change to a liberalized supplier. In December 212, there were a lot of consumers that had not yet changed, but this penalty initiated the transition and in the first ten months of billion consumers contracted a liberalized supplier, which weighted 7.7% of total market and represented one-third of consumers in the LRS as of December This denotes the rapid change in the market. Regarding the Spanish market, by December 212 EDP had 1.5 million consumers (74% in the liberalized market) and supplied 2,252GWh (96.5% in the liberalized market). Contrary to Portugal, Spain started the liberalization process much earlier and has fewer consumers in the regulated regime. In addition, the Spanish regulated regime is not similar to the Portuguese since consumers can only choose to be supplied in the regulated market if they are considered lower voltage consumers 53, with no anticipated change to this regime. LRS are determined by the Spanish government law. Overall, EDP s market share remained stable at around 9% in the liberalized market from 29 to 212. Valuation The key value drivers of this segment are estimated demand, evolution of market share, consumers preferences, evolution of margins, and prices. Consumption of electricity is strongly connected to economic growth, the Human Development index (HDI), and energy prices. Since the variables are not stationary and co-integrated, we relied on first differences and/or growth rates in order to project consumption 54. Since Portugal recently underwent an increase in the value added tax, from 6% to 23%, we do not have sufficient observations to quantify its impact through dummy variables. As such, this adjustment will be reflected in our underlying price trajectory going forward. Regarding prices growth we estimate an average increase per year of 2% 55 in the long run. Given the historical high energy prices in Portugal, initial price growth rates will be above this long run threshold but they will slowly converge towards this equilibrium. 52 ERSE 53 Contracted power voltage lower that 1KW Consumers with contracted power voltage above this value have to buy from a liberalized supplier since July ; R 2 =.79 ; R 2 =.49 Data source: IMF, Eursotat, Pordata and INE. 55 World Energy Outlook 213, Table A8, page 139, Energy Information Administration. PAGE 19/33

20 Thousands EDP ENERGIAS DE PORTUGAL Graph 34: EDP's expected sales in Spain (GWh) LRS Liberalised When limited to 4 times per year, changes in supplier will not impose costs on consumers which implies a higher propensity for changes in providers and stronger market competitiveness. Nowadays companies offer integrated packs of electricity and gas, and even if a particular company has a worse option for an individual service it can offer a better option for packages of services. This impact will be included in the estimations of margins and sales. Due to ERSE s penalty in transition tariffs we believe that only a residual part of consumers will remain in the regulated market and by 216 all consumers are supplied in the liberalized regime. Note that in Portugal a marginal part of population (estimated in less than one percent) will remain in the regulated supply. In Portugal prices charged to small consumers are very stable with changes in invoices of about 1.5%. However, the change for large consumers is wider and EDP is not able to offer competitive prices 56. Regarding Spain, according to CNE EDP has offered the lowest prices in the first six months of 212. This is also true for smaller companies and EDP has managed to detain between the third and fourth position for large consumers 57. Changes in consumer s preferences: more demanding consumers and increasing use of electric vehicles Changes in consumer s preferences will take into account the change in propensity to use electric cars and electronic devices. We believe consumers will be more demanding when choosing electronic devices and choose the ones with lower electricity consumptions. However, there is the opposite tendency to use more and more electronic devices (electric intensity of the economy 58 ). The net effect is an increase in demand but at a slower pace. According to a recent study about forecasts of evolutions of electric vehicles in 22 59, during 212 Portugal counted with electric vehicles and Spain with 787 which represented 1% and.4%, respectively, from all electric vehicles in the world. By 22 it is estimated that 37,692 electric vehicles will be available in Portugal and in Spain which represent 5.3% and 12% from total cars estimated in 22. Even if electronic vehicles correspond to a market with high potential, large developments are not expected in the near term. Still some companies have launched much more appealing prototypes, with better technology 6 and lower production costs, effectively reaching a higher portion of the population. 56 NOVA Research Team simulation through ERSE s resources. 57 «Informe de Supervisión de las ofertas del Mercado minorista de gas y electricidad recogidas en el comparador de ofertas de la CNE» primer semester de 212, CNE. 58 According to Electricity consumption forecasting in Italy using linear regression models by Vicenzo Bianco, Oronzio Manca, Sergio Nardini, energy 34 (29) p Global EV Outlook- Understanding the Electric Vehicle Landscape to 22. International Energy Agency. April 213, page 1. 6 EIA. PAGE 2/33

21 As competitiveness increases, we expected lower margins. There is an increasing competition that led to a decrease in margins and as a response companies are trying to increase market shares. For instance, EDP has launched campaigns targeted at consumers who prefer electronic means of communication. In addition, EDP has the advantage of being the incumbent as a large proportion of people, who are often adverse to change, were supplied by the EDP group 61. EDP has to position itself as a dynamic corporation who is willing to adjust to consumer requirements in order to face the increased threat of new entrants. A particular example lies in the DECO auction won by Endesa which has united around 6 thousand consumers and offered a 5% discount over the consumption of electricity. As a result EDP offered lower prices through discounts for both consumption and contracted power capacity, with reductions ranging from 5.8% to 7% depending on consumptions. Furthermore, as the market becomes more liberalized, further efforts will be required. Lower investment is expected since consumers will be keener to use electronic support in detriment of physical stores. As competitiveness increases, we expect lower margins. Table 1: Supply in Portugal Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT (24) (2) 3 (7) (1) (8) 1 Depreciation and Amortization Other Adjustments (8) (9) Cash Flow from Operations (17) (5) CAPEX (12) (25) (16) (17) (2) (22) (25) (28) Operating NWC 17 (94) Other LT Operating Assets and Liabilities (72) (69) Cash Flow from Investing Activities (67) (188) (1) (15) FCF (84) (193) PV FCF 136 t 29.5% Terminal value (PV) 12 g 3.% Value Supply Portugal per share WACC 6.93% Table 11: Supply in Spain Valuation (millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT Depreciation and Amortization Other Adjustments 1 Cash Flow from Operations CAPEX (8) (9) (7) (8) (1) (13) (15) (18) Operating NWC 14 (175) Other LT Operating Assets and Liabilities (13) (131) (5) (1) Cash Flow from Investing Activities (124) (316) (8) FCF (116) (296) PV FCF 225 t 3.% Terminal value (PV) 1 g 3.% Value Supply Spain per share WACC 6.85% 61 Power to choose: An Analysis of Consumer Bahavior in the Texas Retail Electricity Market, Ali Hotaçsu, Seyed Ali Madanizadeh and Steven L. Puller, September 211. The main conclusions are that consumers continue to be supplied by the incumbent even though they might obtain great advantages from other suppliers and that this market share advantage diminished over time. PAGE 21/33

22 Thousands EDP ENERGIAS DE PORTUGAL 7. Gas in Iberia Graph 35: EDP's Consumers in Portugal Portugal and Spain do not possess natural gas wells and therefore their activity consists in storage, distribution and supply, being the second player in the Iberian market. Similarly to electricity, the gas activities are regulated in what concerns storage and distribution, and are liberalized in supplying. Additionally, this segment is also evolving in terms of integration of the Iberian market to create Regulated Liberalized the MIBGAS 62, in which ERSE and CNE are working in. In Portugal, EDP operates through EDP Gás Distribuição, EDP Gás Universal, and EDP Gás Propano, having supplied 7.46TWh to 318,552 consumers in 212, which corresponds to a market share of 16.2% in commercialization. ERSE is responsible for regulating the distribution and the last resort supply of gas. In the current regulatory period, which ranges from 213 to 216, the remuneration of these activities will be indexed to the 1Y Portuguese bond yield with a floor and a cap of 7.83% and 11.%, respectively 63. During its first year the pre-tax rate was fixed at 9.% and we expect a downward revision in the following years due to a decrease in the 1Y bond yield. The sector has passed through a liberalizing process 64 and since mid-212 there has been a transitory period similar to the electricity case, where the schedule for the removal of the regulated tariffs was established in DL 74/212, March 212. This transition began in June 212 for consumptions between 5 m 3 and 1. m 3, and December 212 for consumptions below 5 m 3. There is also a transition period until 214 for the first consumers and until 215 for all others. Regarding the Spanish market it is organized in LRS, established by government and liberalized suppliers 65. EDP operates under Naturgas Energía (NGE), and during 212 it supplied 55,79TWh with 1,8 thousand distribution points and 1,32 km of network which is used for both transportation and distribution. Recently, EDP finished the disposal of the transmission assets detained to Enagás for an EV of 258 million, which represent an average of 26.5 million of regulated revenues per year in 211 and 212. On the other hand, EDP acquired 62 The Iberian Market for Natural Gas. 63 Parâmetros de Regulação para o Período dos anos gás de a , June 213, ERSE, page 183. The minimum corresponds to an average yield of 2.5% and the maximum to an average of 21.5%. 64 There is a Directive from the European Counsel and Parliament 29/73/CE July 29 that establishes the need to increase the competition and the liberalization of the segment. The directive was later transposed to a law in DL 77/211, June Regulated through Hydrocarbons Act 34/1998 from October 1998; RDL 949/21 from August 21; and RDL 1434/22 from December 22. More recently, the Act 12/27 from July 27 modified Hydrocarbons Act and adopted the ED 23/55/EC, later repealed by Directive 29/73/CE. PAGE 22/33

23 another 5% in NGE with an implicit multiple EV/EBITDA of 9.4, which amounted to 95% of NGE s capital 66. Valuation To value this segment it is crucial to analyze the evolution of demand, market share and prices. Source: REN. 44% 36% 28% 2% 12% 4% Chart 41: Iberian Market share in gas (Percent) Gas Natural Fenosa EDP Iberdrola Endesa Galp Total Iberian demand has evolved according to chart 4 in which we can see that the biggest part of demand came from conventional demand (households and industrial clients) and that demand for electricity generation has been decreasing exponentially since 26. According to REN the conventional demand is expected to growth at an average rate of 2.2% from 213 to 223 and the total demand is expected to grow at an average of 4% per year in the same period 67. However, according to EIA 213, the consumption of natural gas is expected to be much lower, at just a 1.3% per year until 24. Regarding prices, we can see that they remain historically low, although we expect an increase of 3.4% per year on average until In what concerns market shares, as we have seen in graph 2, they have been relatively stable since 29 for EDP despite losing its third position to Galp in 212. We do not expect great changes in the market share of EDP, despite a slight decrease in the short term. For the sake of the valuation, CAPEX will be considered equal to depreciation and the new tax of.85% of assets will be taken in consideration. Table 12: Gas Valuation ( millions) E 214 E 215 E 216 E 217 E 218 E NOPLAT Depreciation and Amortization Other Adjustments (58) (2) (63) (69) (65) (72) (92) (72) Cash Flow from Operations CAPEX 73 (11) (63) (64) (66) (63) (73) (74) Operating NWC 9 (181) 56 2 (6) (24) Other LT Operating Assets and Liabilities (157) (14) Cash Flow from Investing Activities (75) (431) (3) (17) (47) (32) (13) (56) FCF 193 (13) PV FCF 1,129 t g WACC Terminal value (PV) 1,83 Portugal 29.5% 3.% 7.2% Value Gas 2, per share Spain 3.% 3.% 7.2% 66 EDP currently detains 99.87% of HC Energía (and consequently 95% of NGE) because Liberbank S.A. had a put option of its 3.13% capital in HC which exercised the selling of 3%, for which EDP has to pay 16 million the price is indexed to EDP s share price. Liberbank still possess the option to sell the remaining.13% until December Cenários de Evolução da Procura de Gás Natural, Período , from REN Page EIA 213, table A1, page 122. PAGE 23/33