INITIATION COMMENT. Iberdrola Renovables, S.A. (SIBE: IBR) Wind Leader Seeking Incentives. Outperform Average Risk

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1 WEEKS 14DEC07-12JAN10 Rel. MSCI EUROPE HI-06MAR LO/HI DIFF 75.74% AS O N D J F M A M J J A S O N LO-31OCT D J F M A M J J A S O N D J HI-11JAN HI/LO DIFF % Royal Bank of Canada Europe Limited Nick Hyslop (Analyst) ; nick.hyslop@rbccm.com Andrew Dunn (Associate) ; andrew.dunn@rbccm.com CLOSE CLOSE 3.41 LO-31OCT PEAK VOL VOLUME FY Dec 2008E 2009E 2010E 2011E Adj EPS - FD P/AEPS 37.9x 37.9x 28.4x 22.7x EBITDAR (MM) 1, , , ,136.8 Revenue (B) EV/EBITDA 14.4x 13.5x 10.8x 9.7x Adj EPS - FD Q1 Q2 Q3 Q A 0.02A 0.00A 0.04A A 0.01A 0.00A 0.05E E 0.01E 0.00E 0.06E EBITDAR (MM) A 233.2A 196.8A 417.6A A 243.6A 232.0A 583.3E Revenue (B) A 0.4A 0.4A 0.7A A 0.4A 0.4A 0.9E E 0.6E 0.5E 0.9E All values in EUR unless otherwise noted. (SIBE: IBR) Wind Leader Seeking Incentives Outperform Average Risk Price: 3.41 Shares O/S (MM): 4,224.0 Dividend: 0.00 Strategic Shareholders: Iberdrola - 80% INITIATION COMMENT JANUARY 13, 2010 Price Target: 3.70 Implied All-In Return: 9% Market Cap (MM): 14,404 Yield: 0.0% Avg. Daily Volume (MM): Event We are initiating coverage with an Outperform, Average Risk rating. Investment Opinion Iberdrola Renovables is the world leader in renewable energy, focusing primarily on wind which we believe is one of the most commercial forms of renewable energy. According to BTM, in the wind market is set to grow at a CAGR of 22% and we forecast Iberdrola Renovables will have earnings growth of 23% CAGR through to Next Phase of Growth to be Led from U.S. We estimate that Iberdrola Renovables will have 3.5GW of installed operating wind capacity spread across 16 U.S. states by the end of this year. Iberdrola Renovables has been the biggest beneficiary of the ARRA grant program to date and although the U.S. pricing environment is less generous than other regions, the high load factors of 34%+ provide adequate compensation, deriving an IRR of c 9%. Any move to a Federal Renewable Portfolio Standard could provide a material boost. Speed Bumps Evident in Spanish Market. Although at the end of 2008 Spain accounted for 50% of Iberdrola Renovables' installed capacity, we believe this ratio will fall as the growth in the Spanish renewable market slows. Renewable tariffs have contributed to a ballooning tariff deficit and plans to reduce this deficit are likely to weigh on the future growth potential. Group ROCE is Set to Rise as Portfolio Matures, but IRRs are Healthy. We calculate that the returns on capital employed (ROCE) at the group level for Iberdrola Renovables are currently only 5%, which appears low. However, wind farms involve an upfront investment followed by a 20-year dividend stream with no further capex. We model each geographic area and we calculate the current IRRs for Iberdrola's installed base, and future projects in the U.S. are 9.0% and 9.4% in the U.K. Valuation and Recommendation Our DCF valuation values Iberdrola's shares at 3.75 per share using a WACC of 6.8% and a terminal value of 10% of the project value. Our sum-of-the-parts valuation derives a fair value of 3.70 per share and we initiate with an Outperform Recommendation. We would look to improving legislation and power prices as potential catalysts to drive our price target. Priced as of prior trading day's market close, EST (unless otherwise noted). For Required Non-U.S. Analyst and Conflicts Disclosures, see page 27.

2 Investment Thesis Iberdrola Renovables is the world leader in renewable energy, focusing primarily on wind which we believe is one of the most commercial forms of renewable energy. According to BTM, the wind market is set to grow at a CAGR of 22% from 2009 to 2013 and we forecast Iberdrola Renovables will have earnings growth of 23% CAGR through to Iberdrola s wind rollout is dependent on renewable legislation, which provides the supporting legal framework to encourage investment in low-carbon energy generation. For Iberdrola Spain, the U.S. and the U.K. are the primary jurisdictions that will affect wind development. Spain s feed-in tariff has provided a stable and clear renewable regulatory regime, which has driven impressive growth in installed wind capacity. However, we believe there are funding issues in Spain that will curtail the rate of future growth so Iberdrola s focus will move to both the U.S. and, to a lesser extent, the U.K. where the regulatory drivers are becoming more attractive. We are initiating coverage with a rating of Outperform, Average Risk. Next Phase of Growth to be Led from U.S. We estimate that Iberdrola Renovables will have 3.5GW of installed operating wind capacity spread across 16 U.S. states by the end of this year. Half of this capacity is concentrated in four states that have RPS standards clearly indicating what can be achieved through attractive incentives. Iberdrola Renovables has been the biggest beneficiary to date of the ARRA grant program and although U.S. pricing is less generous than in other regions, the high load factors of 34%+ provide adequate compensation, deriving an IRR of c 9%. Renewable legislation is improving, and prospects for a federal RPS and a cap-and-trade system lead us to believe Iberdrola Renovables will continue to focus on the U.S. for the next phase of growth. Speed Bumps Evident in Spanish Market Although Spain accounted for 50% of Iberdrola Renovables installed capacity at the end of 2008, we believe this ratio will fall as Spanish renewable market growth will slow. Spanish renewable legislation has been particularly transparent and allowed for the impressive rollout seen to date. However, our view of the legislation indicates a slowdown in the rate of growth in Spain and we believe that paying the tariff deficit down will impact future growth. Renewable tariffs have contributed to a ballooning tariff deficit and plans to reduce this deficit are likely to weigh on future growth potential. Group ROCE is Set to Rise as Portfolio Matures, but IRRs are Healthy We calculate that the returns on capital employed (ROCE) at the group level for Iberdrola Renovables are currently only 5%, which appears low. However, wind farms involve an upfront investment followed by a 20-year dividend stream with no further capex. Despite being the global leader, Iberdrola is still in its growth phase, increasing its debt and investing heavily in building out its portfolio of wind farms and this has depressed its current ROCE. During the payback years operating profit rises, debt is paid down and consequently ROCE rises gently from here and we forecast it reaching 8.8% by Looking 20 years forward, if the future investment capex is stopped by 2015 then ROCE rises to mid teens. We model each geographic area and we calculate the current IRRs for projects in the U.S. are 9.0% and 9.4% in the U.K., both below the 10.4% achieved from the Spanish portfolio. We Initiate with an Outperform, Price Target 3.70 per Share Our DCF valuation values Iberdrola's shares at 3.75 per share using a WACC of 6.8% and a terminal value of 10% of the project value. Our sum-of-the-parts valuation derives a fair value of 3.70 per share and we initiate with an Outperform recommendation. We would look to improving legislation and power prices as potential catalysts to drive our price target. 2

3 Company Description Iberdrola Renovables is the largest developer and operator of wind farms in the world, with 10.5GW installed at the end of Q3/09 and a pipeline of more than 57.4GW. About half of its wind assets are located in Spain, a third are in the U.S. with the remainder in the U.K. and Rest of the World. The company also has a few non-wind assets comprising 342MW of mini-hydro and two gas cycle plants totalling 606MW. However, the company's business activity is predominantly wind energy. Iberdrola has started to develop other technologies such as the energy coming from biomass and tides. Exhibit 1: Installed Capacity (MW) and Load Factor (%) (L), and EBITDA (R) % % 30% 25% Mini-hydro 2% Wind RoW 5% Gas 9% Thermal 5% % 15% 10% 5% Wind UK 8% Wind US 14% Wind Spain 57% 0 Wind Spain Wind US Wind UK Wind RoW Mini-hydro 0% Source: Company reports Ownership Structure Limits Free Float Following the acquisition of Scottish Power in 2007, Iberdrola s renewable energy operations were spun out as Iberdrola Renovables with Iberdrola maintaining a controlling 80% stake. This structure enables Iberdrola Renovables to finance its growth from the balance sheet of its parent Iberdrola. We would expect further equity to be raised via the Iberdrola Renovables listing as another source of equity financing, but only when market conditions allow. Since flotation, weak equity markets and poor power prices have generally prevailed, which has effectively closed this option, in our view. Gamesa Strategic Agreement Provides Competitive Advantage Through its parent s 14% shareholding in Gamesa, Iberdrola Renovables has a strategic supply agreement with Gamesa covering 70% of its needs up to In June 2008 Iberdrola Renovables announced a strategic agreement with Gamesa comprised of a 4.5GW turbine supply contract for projects in Europe, the U.S. and Mexico, and an agreement to jointly develop and manage wind projects in Spain and Continental Europe. The turbine agreement was the largest turbine supply agreement ever signed and we believe it enabled Iberdrola Renovables to achieve favourable pricing and contract conditions.. Although Gamesa is Iberdrola Renovables s favoured turbine supplier, it also has signed sizeable agreements with General Electric, Mitsubishi, Suzlon and Alstom Ecotècnia, and we would expect Iberdrola Renovables s dominant position in the wind market to allow it to negotiate attractive terms. Iberdrola is the largest shareholder of Gamesa, holding a 14.1% stake after selling 10% for million in June Iberdrola Renovables also announced at this time that it was acquiring Gamesa s 900MW wind projects in the U.K., Mexico and Dominican Republic for 65 million, although this changed subsequently and Gamesa s U.K. pipeline now forms part of the agreement, replacing the acquisition of the Dominican Republic assets, while acquisition of one of Gamesa s Mexican projects is still possible. Under the joint development agreement, Iberdrola Renovables and Gamesa will develop their own pipelines in Spain and Continental Europe independently but under a joint advisory committee until 30 June From 1 July 2011 IBR has the option to either acquire Gamesa s businesses in these countries or to set up a joint venture to be 75% IBR owned and 25% Gamesa owned, which will manage both companies pipelines. The transition period to 30 June 2011 is intended to simplify certain technical aspects of a potential medium-term acquisition of Gamesa s Spanish and Continental European wind pipeline. The net effect of the joint development agreement was to add 10GW to Iberdrola Renovables s pipeline (4.75GW in Spain and 5.25GW in Continental Europe). 3

4 Returns on Capital Employed are Deceptively Low but Should Rise Over Time We calculate that the returns on capital employed (ROCE) within Iberdrola Renovables are currently only 5%, which appears low versus the IRRs of c 10% which we believe typical wind projects attract. However, wind farms involve an upfront investment followed by a 20-year dividend stream with no further capex. Despite being the global leader, Iberdrola is still in its growth phase, increasing its debt and investing heavily in building out its portfolio of wind farms, and this has depressed its ROCE. During the payback years, operating profit rises, debt is paid down and ROCE rises gently from here. We forecast it reaching 8.8% by Looking 20 years forward, if the future investment capex is stopped by 2015 then ROCE rises to mid teens. Exhibit 2: ROCE is Very Low but Should Rise over Time (%) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% E 2010E 2011E 2012E 2013E 2014E 2015E 2016E Source: RBC Capital Markets estimates However, we estimate that the after tax Internal Rates of Return (IRR) on Iberdrola s projects are all about 10% based on our 20-year DCF analysis of each of the four regions. We include the spend to date in our IRR calculations below, so these represent an average of IRRs from past investments blended with the forecast IRRs on future projects. Iberdrola itself would indicate IRRs of c 9% in Spain, 10% to 11% in the U.S., 12% in the U.K. and 9% to 10% in RoW. However, these forecasts reflect the returns on current investments, whereas our rates include the impact of past acquisitions and investments. Exhibit 3: Estimated IRRs on projects c 10% Region IRR (%) Spain 10.3% U.S. 9.0% U.K. 9.4% RoW 11.1% Source: RBC Capital Markets estimates By way of example, in the U.K. we would have expected onshore IRRs to be closer to 14% on current peer group projects and historically some projects will be even better than that. Therefore, Iberdrola Renovables 9.4% IRR in the U.K. looks too low. The difference lies in the assumed sunk capex cost for the U.K. assets. The annual depreciation charge of c 78 million would imply a sunk cost of 1560 million (20x78) as the original capex cost to build the wind farms based on a 20-year straight-line depreciation charge. We forecast an installed wind farm MW of 875MW, which would imply that the average cost of a MW of wind in the U.K. is 1.8 million. This is certainly higher than the 1.55 million we expect as the average per MW cost for capex even for 2010, and these costs have been rising over time. We presume that the carried value of the U.K. wind assets is much higher than the build cost, which should have been lower but the acquisition of the Scottish Power business by Iberdrola reset the carrying value. This makes the IRR on the whole Iberdrola Renovables U.K. business appear low. 4

5 Rising Power Prices Remain the Best Indicator for Improving Valuations With no input energy cost, once the capex on a wind farm has been expensed, the value becomes highly dependent on the achieved power price. As the achieved power price improves, either from the underlying wholesale electricity price or from the improved incentive scheme, this is the biggest single driver of wind farm value, in our view. Clearly while lower costs of capital, capex per MW and maintenance can all have an influence, we believe achieving a higher value for the output is key. Within the Spanish market, Iberdrola Renovables sells the majority of its output through the market-premium option which has achieved a higher rate (see below) than the feed-in tariff option. Under this regime Iberdrola Renovables has a power purchase agreement (PPA) with its parent Iberdrola, which provides stability to revenues. Similarly, in the U.K. Iberdrola Renovables has longterm PPAs for about 80% of its wind output with Scottish Power, which was acquired by Iberdrola in This is reviewed annually and the price for the following year is set each summer. We believe the total price in 2009 will be 112 per MWh and that for next year this will fall about 10%. In the U.S., Iberdrola has a relatively smaller presence (through Energy East) and so Iberdrola Renovables sells its output to a much more diverse customer base, including large utilities and public and private investment companies spread across the states. Power Price Forecasts Point to Recovery Power prices are difficult to forecast and are loosely correlated with overall economic and industrial activity. Recent forecasts from Redpoint and Poyry both indicate a recovery in the electricity price over the next few years, which we reflect in our model. Exhibit 4: Redpoint and Poyry Forecast a Modest Rise in U.K. Electricity Prices (Baseload Price ( /MWh)) E 2012E 2014E 2016E 2018E 2020E 2022E 2024E 2026E 2028E 2030E Redpoint Poyry Source: Redpoint (August 2009), Poyry (July 2009) Load Factors Remain Stable Through the Years Wind output will vary considerably throughout a single year, with lows during the summer months and highs during winter. However, average load factors between years are surprisingly consistent (Exhibit 5). On an annual average basis, therefore, weather tends to have a relatively small influence on output. 5

6 Exhibit 5: Average Annual Load Factor Tends to be Consistent Between Years Source: Renewable Energy Foundation 6

7 Global Wind Industry Leadership Position Adds Value Iberdrola Renovables is the largest global wind farm operator by a clear margin, with close to 9GW in operation at the end of 2008 and we forecast 10.4GW of wind by the end of We believe the total installed wind capacity globally will be over 150GW by the end of 2009, giving Iberdrola a 7% market share. Iberdrola s early lead in an industry which continues to experience strong growth gives it a number of advantages, in our view: An established record as a credible developer and unparalleled operating experience; Established relationships with turbine suppliers, ensuring the best possible terms through sheer scale; One of the largest future-prospect lists; and Geographic diversity, enabling it to take advantage of the best regulatory regimes. The regulatory framework for renewables continues to improve, in our opinion. Although short-term changes as regulation ebbs and flows may be negative, the overall environment on a long-term view is very positive as the world transitions to low-carbon energy. Exhibit 6 shows Iberdrola s dominant position. Exhibit 6: Top 15 Global Wind Farm Operators by Installed Operating Capacity (GW), Iberdrola Renovables FPL/NextEra EDP Acciona Long Yuan Datang Corporation EDF Endesa E.On Eurus Energy Holding Babcock Brown MidAmerican Energy International Power AES Cielo Source: BTM Consult, March 2009 Global installed wind capacity is forecast to grow from 122GW in 2008 to 343GW in 2013 (a compound annual growth rate of 23%), according to BTM Consult. The Americas are expected to maintain their dominance in the sector with their global share growing from 24% in 2008 to 27% or 94GW in We forecast that Iberdrola s focus on the U.S. will make this the largest region for the company by 2015 when we expect 44% of its wind assets to be based in the U.S. With its high load factors and relatively lower operating costs, the U.S. is going to be a key driver for Iberdrola over the next few years. 42% of Iberdrola s 57GW pipeline is in the U.S. (Exhibit 7). 7

8 Exhibit 7: Iberdrola s Pipeline Shows U.S. to Provide the Next Phase of Growth (Pipeline in % of Total) UK 9% RoW 24% USA 42% Spain 25% Source: Company reports We expect Iberdrola to maintain its focus on Spain, the U.S. and the U.K. as it continues to roll out its wind farms. Exhibit 8: Steady Growth in Cumulative Industry Global Installed Wind Capacity (MW) E 2010E 2011E 2012E 2013E Americas SE Asia Other EU Germany Spain France UK OECD Pacific Other Source: BTM Consult, March

9 Exhibit 9: Strong Growth in Industry Wind Capacity Forecast in Iberdrola s Target Regions of the U.S.(MW) E 2010E 2011E 2012E 2013E Americas Spain UK Source: BTM Consult, March 2009 By extracting the countries relevant to Iberdrola Renovables from Exhibit 10, the magnitude of the opportunity for Iberdrola Renovables in the Americas becomes apparent. Although Spain currently accounts for the largest proportion of Iberdrola Renovables assets, we believe the U.S. will become increasingly important as the company develops its pipeline. The chart below shows Iberdrola s pipeline including the 10 GW from the strategic agreement with Gamesa which is shown separately. Exhibit 10: Risked Iberdrola Renovables Pipeline at Q3, 2009 (MW) 35,000 30,000 30,532MW 25,000 20,000 15,000 13,305MW 10,000 10,000MW 5,000 1,996MW 0 Strategic Agreement Probable (<20% chance) Likely (40-50% chance) Highly Confident (>95% Spain U.S U.K RoW chance) Source: Company reports 9

10 Exhibit 11: Installed Wind Capacity Compound Annual Growth Rate (%) 40% 35% 30% 25% 20% 15% 10% 5% 0% UK France SE Asia Americas OECD Pacific Other EU Spain Germany Source: BTM Consult, March 2009 BTM Consult forecasts that the U.K. will have the highest global CAGR, at almost 35% between 2008 and 2013, albeit coming from a relatively low base. 10

11 Key Regulatory Developments Iberdrola s wind rollout is dependent on renewable legislation, which provides the supporting legal framework to encourage investment in low-carbon energy generation. For Iberdrola Spain, the U.S. and the U.K. are the primary jurisdictions that will affect wind development. Spain s feed-in tariff has provided a stable and clear renewable regulatory regime, which has driven the impressive growth in installed wind capacity. However, we believe there are funding issues in Spain that will curtail future growth so Iberdrola s focus will move to the U.S., and to a lesser extent, the U.K. where the regulatory drivers are becoming more attractive. United States Improving Renewable Legislation We estimate that Iberdrola Renovables will have 3.5GW of installed operating wind capacity spread across 16 U.S. states by the end of this year. Half of this capacity is concentrated in four states (Exhibit 13). We forecast Iberdrola to receive an average of $72 per MW under the current legislation, but believe that this will rise to c $75 over the next couple of years. Renewable-energy companies can claim either the Production Tax Credit (PTC) or the Investment Tax Credit (ITC) in the U.S. The Production Tax Credit (PTC) reduces the income-tax liability for the owners of renewable-energy projects. A tax-paying entity must own the generating asset and sell the electricity to an unrelated third party. For wind, the current incentive is US$0.021 per KWh for 10 years after the facility is placed in service, with an in-service deadline of December 31, The alternative is the Investment Tax Credit (ITC), which reduces income taxes for owners based on capital investment in renewable-energy projects. ITC credits are earned when the capital equipment is placed into service to help offset upfront investments in renewable-energy projects. The production tax credit was extended by three years for wind to However, although the PTC program was extended, its effect was blighted by the lack of tax capacity resulting from the credit crunch. The introduction of the American Recovery and Reinvestment Act includes a number of improved and extended incentives for a range of renewable-energy sources. Under these laws, taxpayers eligible for the PTC can take the ITC or elect to receive a grant from the U.S. Treasury Department instead of taking the PTC for new installations. Iberdrola Is the Biggest Beneficiary of the U.S. Grant Program In July 2009 the U.S. Treasury announced a grant program under the American Recovery and Reinvestment Act (ARRA) which can provide 30% of the capital costs of a wind-farm project. Eligible taxpayers can choose to opt for a grant from the U.S. Treasury instead of the ITC or PTC. Choosing a grant has the benefit of providing upfront cash, and IBR has been particularly successful in securing funds. Payments are in cash and will be made within 60 days of an application being received. Projects must be placed in service in 2009 and 2010 and be operating before 2013 if construction starts before The grant program is a temporary measure intended to boost investment and jobs; hence, payments are made in lieu of renewable-energy production or investment tax credits for the life of the project. To date, Iberdrola Renovables has submitted eight grant applications to the U.S. Treasury Department for wind projects in North America totalling almost 980MW. In September 2009 all eight of these applications were successful amounting to $545.8 million. We list these projects in Exhibit 12. We believe these grants will be treated as deferred income, creating a liability on the balance sheet which will be amortised over the life of the project. Exhibit 12: Iberdrola Renovables Projects Awarded ARRA Grants Project State Size (MW) Peñascal Texas 202 Barton Iowa 160 Farmers City Missouri 146 Barton Chapel Texas 120 Locust Ridge II Pennsylvania 102 Hay Canyon Oregon Pebble Springs Oregon 99 Moraine II Minnesota 49.5 Total Source: Company reports The grant program remains open until October 1,

12 Iberdrola Renovables is Well Positioned for a Cap-and-Trade Program A carbon tax or cap-and-trade program designed to place a charge on carbon emissions from energy production could dramatically alter energy costs. Since wind energy is carbon-free, it will likely become relatively less expensive in such a scenario. Multiple bills have been proposed in Congress but consensus has yet to be achieved. Whilst difficult to quantify the benefit that might accrue to Iberdrola in the event that a cap-and-trade program is adopted, we note that each MW of wind has an equity value in addition to the capital cost of construction and that this equity value would be significantly enhanced by such a program. State Renewable Portfolio Standard (RPS) has Driven Rollout We believe a key driver for renewables in the U.S. will be the adoption of a federal RPS standard rather than the state-by-state system that currently exists. If we look at the RPS by state in the table below, it is clear that in the states with defined RPS targets that are high, Iberdrola has already managed to install wind farms that have been supported by this legislation. Oregon, Minnesota, Texas, Iowa and Illinois account for more than half of Iberdrola s U.S. wind business. These states all have RPS standards that are, on average, much more demanding than some of the others. Perhaps only California could be higher given its RPS, but this is still in Iberdrola s top six states for installed capacity. Iberdrola achieves very different power prices across its U.S. wind portfolio ($60 per MWh in the mid-continent rising to as much as $110 per MWh in the Northeast). Importantly, Iberdrola s thermal gas plant also owns a transmission link from the Northwest down to California where Iberdrola Renovables is able to achieve c $100 per MWh given the state s high RPS targets. This is a valuable strategic asset and leads us to forecast higher US$ prices for power over the next couple of years in the U.S. If a federal RPS were introduced, Iberdrola would be a major beneficiary of the improved pricing that likely would result. Exhibit 13: Iberdrola Renovables Installed Wind Capacity and RPS by State (MW) State MW RPS Oregon % by 2025 Minnesota % by 2025 for Xcel, 25% for others Texas 322 Austin, 30% by 2020, 10GW by 2025, San Antonio 15% by 2020 Iowa MW nameplate renewables Illinois % by 2025 California % by 2020 Washington % by 2020 Pennsylvania % by 2021 New York % by 2013 Colorado % by 2020 Kansas % by 2020 North Dakota % by 2015 Missouri % by 2021 Arizona 63 15% by 2015 South Dakota 50 10% by 2015 New Hampshire % by 2025 Total 3459 Source: Company reports, DSIRE Renewable Portfolio Standard (RPS) Definition. The RPS is a renewable energy market-support policy, voluntarily adopted by certain states, that requires that a minimum percentage of electrical power be generated by renewable energy sources, such as wind power, biomass, small-scale hydroelectric, geothermal or solar energy. Each state voluntarily defines the conditions and renewable quotas recognised in the RPS. Most consist of between 10% and 25% of the renewable supply in the years 2010 to Currently, 29 states and the District of Columbia have implemented the RPS mechanism. The RPS is fulfilled through a system of negotiable certificates that verify that a kwh of electricity was generated by a renewable source. These certificates are referred to as RECs, or Renewable Energy Credits. At the end of each year, electric power generators must have enough certificates to cover their annual quota of renewable energy. If they fail to meet their annual quota, they are fined. 12

13 Spain Legislation Implies Speed Bumps Ahead Spanish renewable legislation has been particularly transparent and allowed for the impressive rollout seen to date. However, our view of the legislation indicates a slowing in Spain and we have growing concern over whether there is a willingness to increase the deficits further. The Spanish Renewable Energy Plan (PER) sets an indicative target for renewables to supply 30.3% of gross electricity consumption by To achieve this, the Spanish government has set targets for installed renewable capacity with 20,155 MW set for wind by Wind and other renewable electricity generators have two options under the Spanish regime (Royal Decree 661/2007): either to feed power to the grid direct and receive a regulated feed-in tariff, or to sell electricity on the open market at a premium price set within regulated upper and lower limits (or cap and floors). Generators are free to choose either option; however, they must commit for a period of at least one year. Tariff and cap-and-floor levels are updated annually by CPI -25bps until December 2012 and minus 50bps thereafter. Every four years, the tariff levels are reviewed taking into account the level of installed capacity and generation against targets, with existing installations grandfathered. Tariff levels have been set in order to ensure an IRR for wind farms selling direct to the grid of 7%, and between 5% and 9% if selling into the wholesale markets. We are forecasting an achieved price for Iberdrola in 2010 of 85 per MWh and 89 per MWh for Exhibit 14: Feed-in and Market Tariffs Under RD 661/2007 ( ) ( /MWh) E Feed-in tariff Reference incentive Cap Floor CPI 3.60% 3.56% 0.54% X factor 0.25% 0.25% 0.25% Source: AEE, RBC Capital Markets Research estimates Exhibit 15: 2008 Market Premium and Fixed Feed-in Tariff Comparison ( /MWh) Premium Pool Price Regulated Tariff Source: AEE The feed-in tariff scheme is valid provided fulfilment of the PER objective (20.155GW by 2010) is not met. In order to prevent this target being exceeded, in May 2009 a registry of preliminary assignment of remuneration was introduced under Royal Decree 6/2009. This requires all new renewable-energy projects to apply for pre-assignment in order to obtain the incentives under 661/2007 and has transferred the approval process from regional government to the Ministry of Energy so that it can better regulate new capacity. The pre-assignment process proved so popular that over 6GW of wind capacity met the criteria, when only 3.7GW was required to meet the 2010 target of GW. Thus, in November 2009 the Spanish government set up a route map to cap the amount of new wind capacity additions to just over 1.7GW per year to This clearly will create a declining growth market for wind in Spain for the next three years. 13

14 Exhibit 16: Spanish Wind Capacity Growth Will be Capped in Future(MW) E 2010E 2011E 2012E Accumulated Annual additions Source: AEE/Invest in Spain/RBC Capital Markets estimates Higher Wholesale Prices Have Favoured the Market Premium Option Since 2005 average pool prices for electricity in Spain have risen (albeit falling recently in 2009), which has made the cap and floor (premium) incentive scheme more attractive than the feed-in tariff. Hence, in 2008 more than 90% of the output from Spanish wind farms was sold through the open market. In 2008 the all-in achieved price under the market premium option was 15/MWh higher than the feed-in tariff option. Exhibit 17: Rising Wholesale Electricity Prices Caused a Shift to Uptake of the Market Premium Incentive Tariff Deficit Likely to Mute Legislative Support in Spain The Spanish government, through the National Energy Commission (CNE), regulates end user electricity tariffs, with renewable energy sources incentivised through premium rate tariffs. Under political pressure to not raise consumers energy bills, the government has maintained tariffs at regulated rates that were below the cost of supply. This created a shortfall, known as the tariff deficit which accrues as a receivable on the balance sheet of Spanish utility companies and reached a cumulative total of about 15 billion last year (Exhibit 18). 14

15 Exhibit 18: Annual Tariff Deficit ( MM) Source: CNE Settlement Report, 2008 To enable utilities to recoup this deficit, the government will allow them to sell debt which will be underwritten by a tariff deficit securitisation fund and has set a target to phase out the deficit completely by To prevent a deficit building after this period, electricity companies will be allowed to charge tariffs that cover the real costs of supply through a series of deregulation steps that ultimately will result in higher tariffs for consumers. In our view, the problem of the tariff deficit, which is forecast to take three years to clear, is not likely to lead to increased legislative support for renewables in Spain in the near future and we would expect IBR to focus on the more attractive markets in the U.S. and U.K. United Kingdom Currently Offers the Highest Incentive The ROC regime in the U.K. currently offers renewable-energy generators one of the best pricing environments. We estimate Iberdrola Renvovables will achieve 112 per MWh in the U.K., which comprises an ROC at 52, CCL at 4.60 and a PPA with parent company Iberdrola at 55. The ROC itself is susceptible to changes in the value of the redistribution of the buyout pool, but we believe the lower price environment will lead to a lower base price PPA next year with Iberdrola and forecast a combined price of 103 per MWh for In the U.K., suppliers have to source an annually increasing percentage of their sales from renewable sources or pay a buy-out price at the end of the obligation period. The number of MWh of eligible renewable electricity that a supplier is obligated to supply is calculated as a percentage of the total amount of electricity supplied to customers in the U.K. over the obligation period. A supplier's obligation is set using the formula below: Supplier's obligation = sales (MWh) * amount of RO (%) Suppliers can meet their obligation by either acquiring ROCs, by paying a buy-out price equivalent to 37.18/MWh in 2009/10 and rising each year with the retail price index; or a combination of ROCs and paying a buy-out price. Electricity generators receive an RO Certificate (ROC) from Ofgem for each 1MWh of renewable electricity that they generate. These are then sold on to the suppliers, which enables them to prove the amount of renewable energy they have sourced throughout the year. Suppliers who do not hold sufficient ROCs to meet their obligation must pay an equivalent amount into a buy-out fund. The buy-out fund is then redistributed pro rata to those suppliers that have presented sufficient ROCs. Renewables Obligation As the buy-out fund is created by suppliers who have failed to meet their targets and hence are obliged to pay the buy-out price, the size of the fund will depend on the obligation target being greater than the number of available ROCs. If an obligated supplier is unwilling or unable to supply the required amount of sales from renewables, it can pay the buy-out price. Any amounts received in this 15

16 manner will be put into a buy-out fund. At the end of the obligation period suppliers complying with ROCs will be given a portion of the fund in proportion to the amount of certificates that they have submitted for compliance in that period. Exhibit 19: The ROC Support Mechanism Buy-out price sets rate suppliers need to pay if they don t present sufficient ROCs ( 37.19/ROC for April 09 to March 10) Where suppliers do not have sufficient ROCs to meet their obligation, they must pay an equivalent amount into a fund, the proceeds of which are paid back on a pro-rated basis to suppliers that have presented ROCs Wholesale baseload power price (variable) + Buy-out price (fixed) + Redistribution of buy-out fund (variable) + Levy exemption certificates (LECs, fixed) = Total Support ROC purchase price Climate Change Levy (CCL) is an energy tax payable by industrial and commercial businesses since April Electricity generated from renewables is exempt from CCL ( 4.75 per MWh in 2009/2010) Source: RWE, June 2008, RBC Capital Markets 16

17 Valuation We have taken a number of approaches to valuing Iberdrola Renovables. Our DCF valuation values Iberdrola s shares at 3.75 per share using a WACC of 6.8% and 10% terminal value. Our sum-of-the-parts valuation derives a fair value of 3.70 per share, which is based on individual DCF valuation for each of the regions and then adds back the non-wind businesses. A peer group valuation analysis is shown below in Exhibit 24, which indicates that Iberdrola Renovables appears to be fairly valued across all valuation metrics. We would look to improving legislation and power prices as potential catalysts to drive our price target. Sum-of-the-parts The table below shows our sum-of-the-parts valuation of Iberdrola. We use a DCF valuation for each of the regions to derive a net present value of the future cash flows from each region. This valuation captures all the future MW to be added in addition to those already operating, but we assume no additional MW are added beyond 2015 when we forecast 21GW of wind. Using our current power price assumptions and costs per MW of wind-development expense, additional MWs have little impact today on the valuation so placing effectively a zero value on the pipeline beyond 2015 is reasonable, in our view. The valuation captures capex which has been expensed prior to the current year, but for all future MW the DCF includes the negative cost of construction in the cash flows. Therefore, EV/MW is based on the installed base in 2008 with its associated capex, and the DCF then captures the equity upside of future MW to be added. The 3.5 per MW for the U.K. looks like an anomaly, but this reflects the higher 14% IRRs that we believe are currently available on onshore wind. Exhibit 20: Sum-of-the-Parts Valuation Points to 3.70 per share 2008 End 2015 EV/MW (Ex Future Capex) Wind Valuation Summary (MW) (MW) Method EV( M) ( M) Spain DCF US DCF UK DCF RoW DCF Total Valuation method EV ( M) Thermal CCGT (MW) M per MW Gas storage (BCM) M per BCM Hydro (MW) M per MW Net Debt ( M) Minorities ( M) Number of Shares (M) Source: RBC Capital Markets estimates We depreciate turbines and development costs on a straight-line basis over 20 years with 10% terminal value ascribed to the site at the end of its life. The terminal value will rise, in our view, over time as a larger proportion of the old installed MW reach the end of their 20-year design life and we believe that there will be potential upside as the portfolio ages, from both the value of the civil works associated with the site with a repowering exercise, and the possibility of extending the life of some wind farms. The DCF is sensitive to the discount factor and the proportion of long-term debt that can be injected into the project is also a variable that will affect the tax charge. We use a discount rate of 6.8% for Iberdrola Renovables. Valuation Sensitivity With no input energy cost, once the capex on a wind farm has been expensed, the value becomes highly dependent on the achieved power price. As the achieved power price improves, either from the underlying wholesale electricity price or from the improved incentive scheme, this is the biggest single driver of wind farm value, in our view. The prospect of a federal RPS in the U.S. would materially increase the value of Iberdrola s U.S. wind farms and is a key catalyst, in our view. The table below shows the effect of annual power price inflation on the sum-of-the-parts valuation per share for Iberdrola Renovables. Our central case assumption is that the power price improves 2.5% per annum from our 2012 forecast rates. 17

18 Exhibit 21: Sensitivity Analysis to Changes in Electricity Price Growth Annual Electricity Price Growth Rate % 2.00% 2.50% 3.00% 3.50% Share Price Source: RBC Capital Markets estimates DCF Valuation We have shown below our DCF valuation for the Iberdrola Renovables Group cash flows. Again we use a group WACC of 6.8% based on a cost of debt of 5%, a risk-free rate of 3.3% and a risk premium of 4.0%. We are forecasting a long term group tax rate of 31%, which gives us a 3.75 per share price target. We assume no further development after 2015 when we assume there is no additional working capital required and assume a value of 10% for the business at the end of 20 years, which is the end of the design life for the wind farms. There will be a rising residual value as the portfolio ages. Exhibit 22: DCF Valuation for the Group Suggests Fair Value at 3.75 per share Cash Flow Valuation Iberdrola Renovables Cash Flow Valuation Units 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E Operating profit ( M) ,213 1,427 1,610 1,781 1,982 2,175 2,242 2,311 Cash taxes ( M) (163) (226) (279) (330) (371) (418) (477) (492) (507) (523) Depreciation ( M) ,049 1,164 1,282 1,392 1,395 1,395 1,395 Working capital ( M) (1,000) 825 (10) (11) (12) (13) (15) (16) 0 0 Net Capex ( M) (1,822) (2,492) (3,017) (2,646) (2,456) (2,533) (2,400) Cash flow ( M) (1,588) (121) (1,170) (510) (65) ,062 3,130 3,184 NPV ( M) (1,588) (113) (1,025) (418) (50) ,926 1,843 1,754 Assumptions WACC Calculation NPV Calculation Growth in EBIT 2017E to 2029E 3.1% Market cap.( M) 13,137 Cash flow value ( M) 17,341 Perpetuity 0.0% Net debt ( M) (3,233) Terminal value ( M) 1,734 EV ( M) 16,370 Terminal value (%) 10% Tax rate 31.0% Estimated EV ( M) 19,075 Capex/Dep 1 Net debt ( M) (3,233) Cost of debt 5.0% Minorities ( M) Share Price (p) 3.1 Cost of equity 7.3% - Risk free rate 3.3% Equity value ( M) 15,842 # Shares Risk premium 4.0% - Beta 1.0 WACC 6.846% Value per share ( ) 3.75 Source: RBC Capital Markets estimates The above DCF valuation is sensitive to the long-term growth in the EBIT, which assumes some improvement in the power price and the WACC used. We have shown a sensitivity analysis below to these two key factors. Our central case above indicates an EBIT growth of 3.1% to derive our 3.75 per share valuation. We use 3.1% as our expectation of achieved electricity price growth, which captures both the incentive and underlying wholesale price growth. 18

19 Exhibit 23: Sensitivity Analysis to Changes in WACC WACC(%) Growth in EBIT 2017E to 2029E 4 2.0% 2.5% 3.1% 3.5% 4.0% 6.3% % % % % Source: RBC Capital Markets estimates A peer group valuation analysis is shown below in Exhibit 24. Across all valuation metrics Iberdrola Renovables appears fairly valued against this peer group, but we believe it fails to fully capture the value in longer-term wind projects. Exhibit 24: Peer Group Comparison Suggests Iberdrola Renovables is Fairly Valued on EV/EBITDA Ticker PE EV/EBIT EV/EBITDA E 2010E E 2010E E 2010E SSE (Adj. to Dec) SSE.L Centrica CNA.L EDP Renovaveis EDPR.LS Theolia TEO.PA* Gamesa GAM.MC Vestas VWS.CO Novera (Adj. to Dec) NOEN.L* Average Iberdrola Renovables IBR.MC *Averages Adjusted for Novera and Theolia negative values. Note: Consensus estimates used for EDP Renovaveis, Theolia, Gamesa, and Vestas. Source: Bloomberg, Company reports, RBC Capital Markets estimates Of Iberdrola s peer group companies, only two are pure-play wind developers/operators: EDP Renovaveis and Theolia. If we compare their enterprise value per MW of installed wind capacity (disregarding projects in construction or planning stages), Iberdrola Renovables again appears to be similarly valued to its peers at 1.75 million/mw. The current cost of replacing the portfolio would be 1.3 million per MW in Spain, RoW and the U.S., and closer to 1.6 million in the U.K. Exhibit 25: EV per Installed Wind Base ( M/MW) Installed Wind (MW) EV ( M) EV/MW EDP Renovaveis , Theolia Iberdrola Renovables , Note: Consensus estimates used for EDP Renovaveis and Theolia. Source: Bloomberg, Company reports, RBC Capital Markets estimates Investment Risks With no cost of fuel, Iberdrola Renovables is heavily exposed and levered to the wholesale electricity price, which is dependent on overall macroeconomic conditions. Iberdrola Renovables relies on supportive legislation for its renewable energy, which can vary depending on political will in Spain, the U.S. and the U.K. Iberdrola Renovables invests significant capital expenditure in wind-power plants, the price and availability of which can fluctuate. As Iberdrola Renovables doesn t generally own transmission lines, it is dependent on third parties for the successful and uninterrupted delivery of electricity to its customers. 19

20 Iberdrola Financial Forecasts We model each of the four main regions for Iberdrola (Spain, the U.S., the U.K. and the Rest of the World) as the basis of our financial forecasts for the company. The key variables are the total development cost per MW, the achieved load factor, the electricity pricing and the apex for each region. Although development costs can vary depending on the size of the wind farm, turbine procurement costs and grid connection costs, etc., we believe the biggest variables are in the price achieved for the electrical output and the load factor associated with the site. High load factors and high electricity sale prices can make wind farms very valuable and potentially worth many times the valuation of less favourable electricity pricing regimes and poorer wind locations. Some of the most valuable wind farms are currently in the U.K due to the generous nature of the ROC regime, and for load factors the U.S. looks particularly attractive. We summarize the current financial elements of our model below. Achieved Electricity Price. We believe this is probably the most important factor in the financial modelling of Iberdrola. With much of the established asset base already on PPAs or feed-in tariff agreements, often with Iberdrola s parent company Iberdrola, it is the pricing that new MW can achieve and what might happen to pricing in the future as PPAs are renegotiated that are key factors for the financial model. Exhibit 26: U.K. Achieves the Highest Power Price per MW 2010E Power Price 2011E Power Price Region ( /MWh) ( /MWh) Spain U.S U.K RoW Weighted Average Power Price Source: RBC Capital Markets estimates Load Factor. The wind does not always blow at the turbines optimum operating speed, and so it will generate only a fraction of its maximum rated capacity. Load factors vary according to site, with average annual values typically in the range of 24%-35%. We factor availability that is typically 97%-98% into our Load Factor (LF) and use the following Less for our modelling. Exhibit 27: Load Factors Are Highest in the U.S. and Lowest in Spain Region Average Load Factor Spain 0.24 U.S U.K RoW 0.25 Average Weighted Load Factor 0.28 Source: Company reports; RBC Capital Markets estimates Total Project Development Costs. We believe current all-in costs per MW are c. 1.3 million in Spain, the U.S. and RoW, but we model a higher figure of 1.54 million in the U.K. Turbine costs are typically 55% of total development cost, which includes the civil engineering works, grid connection and feasibility studies. Operating Costs. Operating costs for a wind farm are predominantly the maintenance costs of servicing the wind turbines and we include any royalties that need to be paid to the land owners in this number. We believe 36,000 to 53,000 per MW pa is the current range of ongoing cost of maintaining wind turbines and paying the land owner. The royalty to the land owner can vary from 1 per MWh produced through to 5% of the revenue generated depending on the agreement with the landowner. For ongoing apex the U.S. has the lowest cost and the U.K. the highest. 20

21 Exhibit 28: Installed Wind Base Forecast Wind Valuation Summary EV( M) IRR (%) ( /MWh) ( /MWh) Installed Capacity 2010E 2011E End 08 H1 09 End 09 End 2010E End 2015 Power Price Power Price Average (MW) (MW) (MW) (MW) (MW) Load Factor E 2015 Spain % US % UK % RoW % Total Source: RBC Capital Markets estimates 21