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Morningstar | Raising Our FVE for RWE to EUR 19.30 Upon Outcome of the Coal Exit Commission; Shares Overvalued

We are raising our fair value estimate for RWE to EUR 19.30 from EUR 17.40 and maintaining our no-moat, stable trend ratings after the German coal exit commission released its recommendations on Jan. 26, welcomed by the German government, which must now pass a law to enforce them. Shares are overvalued at current levels.

The commission set 2038 as the deadline to end coal-fired power generation in Germany. The commission recommends that by 2022, 12.5 gigawatts of coal generation capacity be shut down, 5 GW of which come from lignite plants and 7.7 GW from hard-coal plants. Between 2022 and 2030, coal capacity would be reduced by an additional 13 GW. As expected, lignite-plant closures should be based on ''mutual and contractual agreement,'' according to the recommendations, implying compensation payments.

Lignite plants account for 60% of RWE's German power generation and rely on procurement from RWE's three lignite mines. Therefore, an agreement with the government will have to incorporate compensation for the early closure of these mines, especially the two largest ones, Hambach and Garzweiler, scheduled to run until midcentury. Besides, the coal exit commission said that it wants to preserve the Hambach forest, whose clearance is required to continue operating the mine beyond 2020. In late 2018, a regional court suspended RWE's allowance to clear the Hambach forest until 2020, when final decision is expected. If RWE is eventually not allowed to clear the forest, the early closure of the mine will have a total economic cost of EUR 4 billion-EUR 5 billion, as there will be no compensation. We previously factored in a 25% likelihood of this scenario. After the commission's conclusions, we now believe the likeliest scenario is that RWE and the German government will negotiate the early closure of Hambach, which will be offset by compensation. Consequently, we do not factor in the 25% likelihood anymore, which drives the increase in our fair value estimate.

At this stage, it is impossible to determine the level of compensation, albeit one can assume that it will not be too far from the assets' economic value, as there is supposed to be a “mutual and contractual” agreement. Should no mutual agreement be reached, closures should be legally enforced with “adequate compensation,” according to the agreement. Overall, we assume that the financial impact of early closure will be neutral compared with our DCF-based value of the lignite plants.

Regarding hard-coal plants, their closure will be organized through an auction model under which the lowest bidder will be allowed to operate the plant for a certain time before handling the decommissioning with money received from the auctions process. The impact of hard-coal plants' closure is not significant for RWE, since their profitability is very low and they account for only 10% of RWE's power generation in Germany.

Besides the financial impact for RWE, the other key question after the recommendations of the coal exit commission is the impact on reserve margin and European power prices. Regarding the 2022 deadline, out of the 5 GW of lignite plant closures, 1.8 GW were already planned. Regarding hard-coal plants' closures, out of the 7.7 GW closures by 2022, 1.4 GW were already planned, 1 GW has already been shut down in 2018, and 1 GW is under construction by Uniper that the commission recommends not to start. Altogether, commission's conclusions involve additional closures of 7.5 GW by 2022. On our calculations, that will reduce the German reserve margin in 2022 from around 20% to 10%, which is significant and bullish for power prices. The additional 13 GW of closures by 2030 would mean that the reserve margin would become negative all else being equal. This is even more bullish for power prices, which need to be high enough to encourage the construction of new combined-cycle gas turbine plants, barring the implementation of a capacity market. This is already partially reflected in current German power prices, which have rebounded from EUR 45 per megawatt-hour at the beginning of January to EUR 49/MWh now, roughly in line with our assumptions. Bottom line, against this bullish backdrop for power prices, we would recommend playing European power producers with low carbon intensity like Enel, EDF, or Engie.