European utilities to lay bare impact of volatility in Q1'22 earnings season

The first-quarter earnings season may provide early signs of how the fallout of Russia's invasion of Ukraine is hitting the bottom lines of Europe's power and gas utilities and how the companies continue to battle, and in some cases benefit from, surging energy prices.

Economic sanctions against Russia, combined with a general desire to end dealings in or with the country, promise to fundamentally reshape the European energy market. Barclays analysts called the war, which began Feb. 24, "a major turning point for European energy."

The invasion has "highlighted the failure of European energy policy to provide for security of supply and diversity of energy policy," the analysts said in an April 13 note. "We believe it will have major implications for the utility sector in the short, medium and long term."

In the short term, the invasion has put further pressure on commodity markets after months of already record-high prices due to a global gas shortage, possibly to the benefit of companies with exposure to wholesale power prices. Meanwhile, companies with direct links to Russian gas "face potential tail-risk force majeure" if Russian gas were to fall below contracted levels, Barclays analysts said.

The dynamics point to a mixed picture for European utilities as they prepare to present their financial results for the first quarter. In a select pool of utilities, analysts surveyed by S&P Global Market Intelligence predicted the majority will beat their quarterly EBITDA result on a year-over-year basis but will experience a decline compared to the fourth quarter of 2021.

Utilities have generally outperformed the wider European market so far in 2022, especially since the war in Ukraine began. The EU plans to replace Russian fossil fuel imports with LNG, biomethane and accelerated renewable energy deployment, a strategy that has buoyed green power producers.

"We believe this could improve investors' confidence in renewables targets, allowing the market to discount longer duration pipelines," Credit Suisse analysts said in an April 5 note.

Generation conditions

European power prices have been driven further upward since the war began due to "feared and actual dislocations of Russian energy imports coupled with low Continental European gas storage levels," Barclays analysts said.

In early March, less than two weeks into the war, the EU unveiled a sweeping plan to cut the bloc's Russian gas demand by about two-thirds by the end of 2022, paving the way for complete energy independence from Russia by 2027. Part of the plan includes a requirement to bolster the EU's gas storage reserves, which today are only filled to low levels.

In conjunction with the EU's efforts, European utilities and energy companies, including those that buy gas from the country or operate on the ground, have been scrambling to reduce their exposure to Russia. Most recently, Engie SA's management said April 21 that the company plans to write off close to €1 billion relating to the Nord Stream 2 gas pipeline linking Russia with Germany, which lost its permit in the days before Russia's invasion of Ukraine.

"Overall, the news can be read as reinforcement of a permanent shift away from Russian gas supplies," JP Morgan analysts said April 22.

While generators with merchant price exposure stand to benefit from the higher power prices, earnings could be hit by first-quarter hydro production levels in France, Spain, Portugal and Italy that were significantly below normal, according to Morgan Stanley analysts.

Hydro generators have been among the biggest winners during the recent surge in commodity prices, given their access to wholesale markets and because they do not pay EU carbon emissions fees.

"For hydro operators with strong exposure to these countries ... we see a risk of expensive power volume buybacks, which could lead to weak [first-quarter] earnings," the Morgan Stanley analysts said in an April 5 note, picking out EDP - Energias de Portugal SA, Enel SpA and its Spanish subsidiary, Endesa SA, as examples.

JP Morgan analysts said the weak hydro output should not prevent Endesa from hitting its 2022 EBITDA guidance and even increased their 2023 EBITDA estimate by 1%, reflecting "Endesa's ability to move its realized price for hydro and nuclear close to €60/MWh as legacy contracts roll off." The hydro conditions will have a "meaningful cost" in the first quarter for Iberdrola SA, the analysts added.

Meanwhile, first-quarter wind speeds were higher than average in markets such as Germany and Poland but were lower than average in places such as the U.K., Iberia, France and Italy, resulting in "small headwinds" overall, Morgan Stanley said.

Nuclear power had similar fortunes in the first three months of the year, the analysts said, with weak production in France and the U.K., as Electricité de France SA battled technical challenges at multiple French reactors, but strong performance in Belgium, which may once again benefit Engie, the analysts said.

Threat of intervention

Companies displaying higher-than-usual profits in the first quarter may be faced with government intervention, some analysts said. The European Commission plans to allow EU member states to introduce temporary taxes on windfall profits made by energy companies and to redistribute the funds to consumers.

Industry observers said the plans need to be carefully crafted to avoid creating market distortions and negatively impacting investor confidence. The plans followed a series of proposals outlined in October 2021 to help shield energy consumers from high prices.

"If utilities were to see potentially rapidly rising earnings, we see increasing risk of socialization policies," Barclays analysts said. "The EU-wide 'windfall tax' announcement allows concerted action."

Windfall taxes are indeed "in everybody's minds," Arnaud Cérèze, director of corporate finance for utilities and renewables at Dutch bank ING, said at Wood Mackenzie's European Power and Renewables Conference on April 26. "How this is going to impact the clean generator is definitely a question for the coming months."

Credit Suisse analysts described government intervention in the first quarter as having been "frequent but benign" for the utility sector, leaving profitability largely unaffected.

The analysts said the limited scope of the windfall taxes "is unlikely to result in major disruption to the sector," and there is "more risk to the large trading houses [and] fossil fuel companies."

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