RWE is campaigning for its lignite plant to be considered as backup capacity. I think the likelihood of that successfully resolving the profitability issue of the generation business is low. Meanwhile, the summer trough will provide weak pricing and not much else that could support the share price. The only supportive factor is relative shifts of political risk within Europe. The shares trade in line with the sector and I do not see any premium as justified. There is risk of a short-term correction after the recent good performance.
RWE is on the path of campaign for its lignite operations. The company operates a large fleet of lignite based power generation plants in Germany, which in total account for just short of 40% of the company's generation. The head of lignite generation has said that the company's lignite plant will be as flexible as gas in its ability to serve as backup capacity for renewables.
I agree that the lignite plant has become much more flexible, and RWE has particularly focused on improving technology with the goal of flexibility over many years now. That has yielded results, by and large thanks to the BoA technology (an optimized lignite generation technology that RWE has developed in a unique way for its newer plant generation). On operational grounds, lignite may now come close to gas as far as backup ability is concerned. Management claims it can now ramp up and down capacity by 50% within 30 minutes, which is in line with gas. There is still another question, though, because RWE's lignite plant is larger in scale than what would be envisaged for an average plant size for gas backup plant.
If the company is looking to position its lignite operations for the capacity scheme under discussion, I see the chances as weak. Politically, lignite is badly perceived. The high emission profile is one reason. The connected open cast mining is another. There is a lot of resistance against that, and the state government of North Rhine Westphalia in Germany is looking to reduce lignite mining. It has recently said it is looking for open cast mining to reduce by 300mt by 2030, from currently 1.3bn.
Back to the emissions issue, for the time being, the company benefits from extremely low CO2 costs. But that may change at any time a follow on regime from the current EUETS comes in. It is hard to predict if and when that will occur, but the downside risk is big. And, any increase in emissions allowance costs will not be reflected in the wholesale power price as that will be driven by the soft capacity balance for the foreseeable future. That makes for an operational risk of lignite on the cost basis.
Politically, the emissions profile of lignite will make it unacceptable as backup capacity under the capacity scheme, most likely. The company may achieve a temporary inclusion through skilful negotiation. That could be the case if the backup capacity scheme will be designed very broadly and fuel agnostic. At this stage, there is no clear path to that outcome, and indications are that the scheme will be directed towards gas.
I sense that the company is also looking to improve acceptability of its lignite mining operations in order to counter the threat of output reduction. RWE is diligently highlighting employment and the number of local contracts for business it has handed out. The connection to backup capacity is well brought up from a communication stand point and as said above has value. But the stance of the State government, which includes the Green party, will likely be tough.
RWE has also said that it cannot cope with any further negative impact from the EEG. I agree with that view in the light of the 25% y/y decline of operating earnings in the generation business and the company's well over 4x net debt/EBITDA ratio.
The lignite campaign may yield limited results at best in my view on either of the target topics, acceptability as back-up fuel, EEG impact reductions, and lignite mining protection. What RWE needs is a complete reshaping, or a material change in the power price outlook. The latter is not in sight with futures standing at Eur 35/MWh, and the generation business is not set for any improvement. A complete reshaping will take time.
The shares have performed in line with the European utilities sector, and marginal positive news flow has supported performance. RWE trades on a 14x P/E 2015E, in line with the sector. I cannot see any premium for the business vs. the sector: The company's financial fundamentals are still weaker than those of most of its sector peers. The company is struggling with weak generation profits like its sector peers, but has a less flexible fleet and less exposure to new growth sectors. The only potential for relative upside is a shift in relative political risk within Europe away from Germany and towards France and the UK (see my recent post - Political risk, published June 2014). The "summer trough" on pricing will not bring any positive news flow, and a short-term correction could occur in my view.
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