European utilities on the cusp of a decade-long investment opportunity

03-02-2021 | Visione

These companies have the unique prospect of tackling climate change and continuing to lead the global energy transition. We are constructive on the sector’s credit quality.

Ihor

Okhrimenko

Senior credit analyst

Speed read

European utilities face a unique, decade-long investment opportunity
Winning themes are renewables, decarbonization and EM diversification
We are constructive on the sector's credit quality

The utilities sector is at the forefront of a global challenge to provide affordable, low-carbon and reliable power to a growing population and tackle climate change by decarbonizing its generation fleet. It is also primed to capitalize on the evolution of renewable technologies which in recent years have enabled a rapid decline of the Levelized Cost of Energy for solar and wind.

We are positive about utility companies that are improving the quality of their assets and reducing their cost structure while actively and effectively working towards diversification.

Abundant flows of financial capital, progressive policies and the advancement of technologies made environmental progress possible in 2019, most notably in Europe.¹ Yet much remains to be done across the globe to combat climate change.

The European Green Deal and the 2030 Climate Target Plan represented a step change in EU climate ambitions in 2019 and 2020. The Covid-19 crisis has accelerated this agenda even further, as the decarbonization efforts will be used to support economic recovery. By summer 2021, the European Commission will revise all of the EU’s climate and energy legislation to align it with the new plan.

Figure 1 | Ranking of industries by carbon intensity

Source: Trucost; Bloomberg; Robeco’s analysis.

The European utilities sector is the second most emissions-intensive sector – measured as emissions per capital – contributing to 32% of Scope 1 industrial emissions. This is according to Robeco’s analysis of 424 European companies, across eleven sectors. The utilities sector emits 1kg of greenhouse gas for every EUR 1 in revenue, and for every EUR 1.6 of enterprise value. Can European utilities help reduce emissions, grow revenues and profitability, and improve valuations for the coming decade, all while continuing to champion the global energy transition and without losing to Big Oil?

Figure 2 | EU emissions in perspective

Source: European Environmental Agency report, Nov 2020. The International Energy Agency - World Energy Model Documentation report, Oct 2020. Note: *2030 projection is based on October 2020 World Energy Model (WEM) under the Stated Policies Scenario (STEPS) – its central scenario – which takes into account the policies and implementing measures affecting energy markets that had been adopted as of mid-2020.

According to the International Energy Agency, under the policies adopted as of mid-2020, the EU27 would by 2030 see its emissions reduce by 30% relative to 1990 levels, while its global share would more than halve to 5.7%. The EU’s recently announced decarbonization target is ambitious, aiming to reduce its greenhouse gas emissions by 55% by 2030 and to become net zero by 2050. This is a major increase compared to the former target of an “at least 40%” reduction by the same time.

A steep path towards decarbonization

To achieve this target, the EU will be using a variety of levers and tools such as increasing the amount of renewable energy, promoting energy efficiency, and supporting and broadening carbon pricing. This new proposal is in line with the Paris Agreement objective to keep the global temperature increase to below 2°C above pre-industrial levels. The power segment, mostly represented by utility companies, faces by far the steepest path to decarbonization.

Figure 3 | Decarbonization pathway across sectors

Source: The European Commission 'Stepping up Europe’s 2030 climate ambition' plan, Sep 2020; Robeco's annotations.

Utility outlook for 2021 is supportive

The European utility sector fared relatively well during 2020, having recovered some of the power demand lost from steep declines in the spring. Going into 2021, the sector’s balance sheets are healthy, liquidity is sufficient, credit ratings are steady and earnings are recovering. This is especially true for companies with high shares of renewables and networks, and strong pipelines of investment opportunities for 2021 to 2023.

What we look for in utility credits

We are positive about utility companies that are improving the quality of their assets and reducing their cost structure while actively and effectively working towards diversification. This involves not only moving away from fossil-based and nuclear energy generation activities towards renewable energy sources, namely wind and solar, but also investments in networks, energy efficiency strategies in supply activities, Scope 1, 2 and 3 emissions disclosure with credible emissions reduction targets, and geographical diversification to emerging markets.

We view the credit quality of the sector constructively. Leading utility companies have upgraded their capex programs to prioritize renewables and networks, with leverage Net Debt/EBITDA projections considered to be manageable.

Regarding SDG contributions more specifically, we focus on utility issuers whose activities reflect a positive contribution to the SDG 7 (Affordable and clean energy) and SDG 13 (Climate action) by screening for certain positive and negative KPIs. These include renewables/nuclear generation in the energy mix, sales to emerging markets, nuclear/coal expansion plans, and carbon intensity of operations. We believe companies with these positive characteristics will have more reliable and stable financial performances over the long run.

Robeco’s Active Ownership team seeks to engage with the utility companies to understand their 2030 climate strategies and decarbonization pathways in depth, and to ensure that they are aware that climate change considerations will affect their equity valuations, bond performance and credit ratings in the coming decade.

¹Annual GHG emissions fell the most in the EU27+UK in 2019, at -3.8% vs. South Korea (-3.2%), the US (-2.6%), Japan (-2.1%), Russia (-0.8%), vs. increases in India (+1.6%), China (+3.4%), Iran (+3.4%). These seven countries are responsible for more than 70% of global GHG emissions. Source: The EU’s Joint Research Centre 2020 report.

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