Case study: RWE

Background to the investment case

RWE is a German utility with operations across Germany, the Benelux, Eastern Europe and the UK. Similar to its German peers (E.on, EnBW) it has historically been active along the value chain in power generation, transmission, distribution and supply.

On the generation side, RWE is one of the biggest conventional power producers in Europe. It is also very well known for its large lignite generation fleet, with integrated lignite mining and generation activities in the Rhineland area (West Germany). Lignite is, from an environmental perspective, the least efficient way to produce electricity, given its high CO2 emissions. RWE’s lignite surface mining operations also affect local communities (including the relocation of complete villages).

RWE, similar to all the other German operators, suffered significantly from the German “Energiewende” – i.e. the massively subsidised build-out of renewables (solar/wind) in Germany. As a result of the “Energiewende”, wholesale power prices collapsed. The preferred access of renewables to the power grid also had a “peak shaping” effect on intraday power prices (higher intraday demand meets the higher intraday solar output), making more environmentally-friendly gas-fired plants economically less viable (“out of the money”). Ironically, the importance of lignite has grown given its cheaper input costs (e.g. versus gas), a non-functional CO2 Emissions Trading System (ETS) (CO2 prices too low to penalise lignite/coal generators) and the decision by a Merkel-led government in 2011 (after Fukushima) for an accelerated phase-out of nuclear by 2022. On balance, the country’s CO2 emissions have not really come down given the current set-up of the “Energiewende”. The role of lignite in this puts continuous pressure on German politicians to finally phase-out lignite at some point in the future.

As a side note: Given significant balance sheet pressure as a result of deteriorating earnings, RWE legally separated and bundled its grid/supply/renewable activities in 2016 from conventional power generation in a company called Innogy, followed by an Innogy IPO in the same year to extract more value out of the “good parts” of the group via an equity raise. RWE remained the controlling shareholder in Innogy (77% stake) and it recently announced the sale of this stake to E.on in a very complex transaction, which gives them a minority stake in the new E.on and control over the renewable businesses of both E.on and Innogy via an asset swap.

ESG factor which drove the investment decision

On the ESG side, both the credit and the internal SRI team were very much focused on environmental issues, i.e. RWE’s significant carbon footprint, and this was also a discussion point in several meetings/calls we had with the company in recent years from both credit and SRI perspectives.

We saw the continued rise in renewable energy, more distributed (and decentralised) generation, and overall lower growth in the demand for energy as a result of efficiency improvements as a significant threat for the company. Disruptive technologies, including energy storage, could also challenge the economics of (conventional/centralised) power generation businesses.

In RWE’s case, the significant exposure to lignite made the situation even more delicate. A gradual phase-out of lignite remains very likely at some point in the future, as this will be essential for the country to achieve its national CO2 target. RWE is a typical example of a company with elevated stranded asset risk, with previous managements having for too long ignored the need to shift to more environmentally-friendly types of generation.

Our view was that the level of investment from RWE in renewables could have been higher in the last decade. Whereas its most direct competitor E.on (Uniper) benefitted from a higher share of more environmentally friendly gas-fired generation, for RWE, the need to move away from CO2-emitting types of power generation was very significant.

Market implications

The above idiosyncratic (ESG-related) risks have driven our more cautious positioning, such as in 2015/2016 (see Figure 33). In April 2015, the company issued two (subordinated) hybrid debt instruments in a €1.25 billion transaction to bolster its stretched balance sheet (see Figure 34). Although part of our benchmark indices, we decided not to participate in the dual-tranche deal given the elevated risks in relation to their carbon/lignite exposure.

We benefitted from this decision: The hybrid instruments – initially rated low investment-grade (BBB-/Baa3) – were downgraded in August and October 2015 by both S&P and Moody’s to BB+/Ba1 and thereby lost their investment-grade/benchmark eligibility. This triggered forced selling and a large underperformance of these instruments.

The stranded asset risk has impacted the business risk assessment of the RWE group by the agencies. This in combination with deteriorating credit metrics triggered several rating downgrades.

Key takeaways

• Lesson learnt: do not ignore environmental risks in credit analysis; there are other examples like VW (emissions scandal) or BP (oil spill in the Gulf of Mexico) that underline the importance of considering environmental risk factors in the analysis of individual credits.
• Companies must adapt to climate change and the rise of renewables – companies like RWE have for too long ignored the structural changes in global energy markets.