Equity research

Utilities | Europe
Sector update 4 December 2006

Carbon Derby
Comeback of the fuel switch?
The European Commission has demonstrated that it intends to be tough on Phase II allowance allocations. We now expect average Phase II emissions to exceed total allowances by 313mt/pa. Even more important is that the ECs proposed cap on CDM/JIs leaves a net deficit of 19mt/pa. This means that there is a good chance for the fuel switch to become the marginal form of abatement in Phase II.
Commission gets tough. Last Wednesday the EC ruled on 10 National Allocation Plans

(NAPs), demanding overall cuts of 63.9mt/pa, or almost 7%. The cuts were some 24mt below our estimates and show that the Commission is serious about creating a carbon constraint for Phase II. Following the release of Wednesdays data we have cut our forecast for total Phase II allocations by 76mt to 2,073mt/pa. The cuts are the result of decisions on the 10 NAPs (where the cuts were 24mt/pa above our forecast) and using the methodology the Commission has applied to revise our forecast for the remaining NAPs.
Phase II total allocation forecasts
Phase I allocations mt CO2/pa Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden UK 30.5 8.8 174.4 22.9 245.3 5.7 97.6 33.5 19.0 45.5 156.5 499.0 74.6 31.3 22.3 222.0 4.6 12.3 3.4 2.9 95.3 239.1 38.2 32.9 62.9 Phase II Phase II Phase II 2005 verified Linking Max amt of Draft mt like-for-like emissions mt directive CDM/Jls mt NCF & DKIB (%) CO2/pa 1 mt CO2/pa CO2/pa CO2/pa mt CO2/pa 32.8 63.2 67.3 7.5 101.9 33.5 24.5 39.4 156.1 482.0 75.5 30.8 22.6 200.0 7.7 16.6 4.0 3.0 100.8 276.2 37.9 90.4 41.3 8.3 152.7 25.2 246.2 41.3 8.2 152.2 25.2 236.7 2,150.6 7.5 101.9 33.5 24.5 39.0 145.6 471.0 78.8 30.8 22.6 200.0 7.2 16.5 4.0 3.0 96.9 275.7 37.9 32.5 58.1 33.4 55.3 50.5 5.7 81.2 26.5 12.6 33.1 131.3 473.8 71.1 25.9 22.4 223.1 2.9 6.6 2.6 2.9 80.4 195.0 36.4 72.5 25.2 8.7 181.1 19.3 242.4 2,121.9 20 10 10 10 11 10 10 12 10 12 9 10 22 28 5 10 10 10 10 10 15 10 7 10 36 10 9 5.8 5.5 5.6 0.6 9.7 2.5 1.2 3.8 13.8 54.4 6.2 2.5 4.6 52.1 0.2 0.9 0.3 0.2 9.2 20.0 5.1 7.4 2.2 0.8 55.0 2.3 22.0 293.8 29.0 57.3 56.0 6.2 85.5 25.0 11.6 31.6 138.2 453.1 69.1 25.3 21.2 186.1 3.3 8.8 2.7 2.1 92.2 200.3 33.9 73.7 30.9 8.3 152.7 22.8 246.2 2,073.1 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Phase II cut vs prop. mt CO2/pa (3.8) (5.9) (11.3) (1.3) (16.4) (8.5) (12.9) (7.8) (17.9) (28.9) (6.4) (5.5) (1.5) (13.9) (4.4) (7.8) (1.3) (0.9) (8.6) (75.9) (4.0) (16.7) (10.4) 0.0 0.0 (2.4) 0.0 (274.3)

EC Ruling on 29 Nov

Research Analyst Lueder Schumacher +44 (0)20 7475 2491

lueder.schumacher@bkib.com

EU 27

2,180.5 2,347.3

Source: New Carbon Finance & Dresdner Kleinwort Equity research estimates

Online research: Please refer to the Disclosure Appendix for all relevant disclosures and our www.dresdnerkleinwort.com/research disclaimer. In respect of any compendium report covering six or more Bloomberg: DKIB1 <GO>

companies, all relevant disclosures are available on our website www.dresdnerkleinwort.com/research/disclosures or by contacting the Dresdner Kleinwort Research Department at the address below.

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4 December 2006

JI/CDM limit. Compared to business-as-usual emissions for 2008-12 (on average 2,386mt/pa on our assumptions), total allowances of only 2,073mt/pa would leave a deficit 313mt/pa. Until Wednesday a lot of commentators automatically assumed that the marginal form of abatement would come from the use if Kyoto project credits (which can then be converted to CERs and ERUs that can be used to meet a countries emission reduction targets). However, on Wednesday the Commission also decided to cap the inflow of CDMs (Clean Development Mechanism) and JIs (Joint Implementation). The Kyoto Protocol allows Member States to invest in CDMs (emission reduction schemes in developing countries without an emission reduction target, eg. China, India) and JIs (emission reduction schemes in industrialised countries with emission reduction targets, eg. Russia, Ukraine) to comply with part of their emission reduction commitments. What the EC has now determined is just how big that part can be. The EC stated on Wednesday that: The Commission considers that, as a general rule, installations should be allowed to use JI and CDM credits to supplement their allowance allocation by up to 10% We believe that this statement is slightly misleading, as there is no overall 10% cap. The Commission later states that the Commission takes the following approach to assessing the compatibility of the proposed JI/CDM limits against Annex III to the Directive: The level of effort to reduce greenhouse gases a Member State is required to undertake is determined by assessing the amount of reduction it is required to undertake in relation to: base year emissions greenhouse gas emissions in 2004 and projected emissions in 2010 In the next step, half of the figure representing the highest effort is calculated. This figure is considered to be the maximum overall amount of JI/CDM credits that a Member State can make use of in addition to domestic action. We believe that this method is the main consideration in determining a Member States cap on CDM/JIs. Therefore, there can be three different levels of caps: countries who want to set a cap of less than 10% on the use of CDM and JI credits for compliance (through the so-called Linking Directive) can do so (eg. 9% for the UK) countries who dont specify a maximum amount will automatically receive a 10% cap countries that want more than 10% of their emission reduction targets covered by CDM and JI credits will have their cap calculated according to the method mentioned above (eg. Ireland, Spain) As a result we can already get a good idea of the likely overall cap on CDMs and JIs because we can use the criteria above to calculate the caps the Commission is likely to impose. The fifth column in the table above shows the caps under the Linking Directive and the column next to it shows the resulting overall amount in mt CO2/pa. Even assuming that every countrys limit is used to the max which is unlikely given that some countries did even apply for a cap the total amount of credits that would be allowed into the scheme is 294mt pa, which is less than the 313mt/pa deficit we are currently looking for.

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Europe likely to face significant carbon constraint

2008 mt CO2/pa Predicted emissions Overall Phase II allocations Surplus / (deficit) Maximum CDM / JI supply (E) Net surplus / (deficit) Average emissions 2008-12 Overall Phase II allocations Average surplus / (deficit) Maximum CDM / JI supply (E) Net surplus / (Deficit) 2,292.7 2,073.1 (219.6) 293.8 74.2 2,385.8 2,073.1 (312.7) 293.8 (19.0) 2009 mt CO2/pa 2,336.9 2,073.1 (263.8) 293.8 30.0 2010 mt CO2/pa 2,377.6 2,073.1 (304.6) 293.8 (10.8) 2011 mt CO2/pa 2,427.6 2,073.1 (354.6) 293.8 (60.8) 2012 mt CO2/pa 2,494.2 2,073.1 (421.1) 293.8 (127.3)

Source: New Carbon Finance & Dresdner Kleinwort Equity research estimates

This means that under our current assumptions for 2008-12 emissions and total allowances for Phase II the fuel switch running gas fired plants instead of coal fired ones is set to make a comeback. At current oil prices the cost for the fuel switch is around 30/t (although it has been almost 65/t earlier in the year). However, this does not necessarily mean that the actual cost of the fuel switch will set the price. Instead the necessity for the fuel switch is likely to drive prices towards a level where the industrial response kicks in, ie the stopping of CO2 intensive processes. Once CO2 prices exceed the profit margin on a given product it makes more sense for companies to stop the production process and sell their allowances instead. We believe that this response, or demand side management (DSM) was already evident when CO2 prices traded between 20-30/t. However, the above scenario is our base case, and this can vary significantly depending on movements in fuel prices (+/- 300mt/pa) and GDP growth scenarios (+/- 200mt/pa). Because of the necessity for regular detailed updates on those, as well as developments in the CDM/JI market, we have linked up with New Carbon Finance (NCF) in order to be able to provide as accurate and up-to-date forecast as possible. So while our current forecast indicates that there will still be a net deficit after taking into account the supply of CDMs and JIs, it is important to bear in mind that this net position can swing around wildly. However, while it is far too early to predict the net deficit or surplus with any degree of certainty at this stage, it is the possibility that the fuel switch could yet be the marginal form of abatement that is the most important conclusion from last Wednesdays announcements.

As for Phase I
Well, here the outlook isnt quite as bright. This outlook was not helped by the Commissions stance on banking, ie. the carry-over of allowances from the first to the second trading period. Banking of allowances was at each Member States discretion and 23 out of 25 have decided not to allow for it. Only France and Poland both with significant surpluses (together almost 70mt/pa in 2005) were considering allowing the transfer of surpluses from Phase I to Phase II. Given the pricing differential between Phase I and Phase II allowances, the base assumption was that these surpluses would be transferred into the next trading period, thereby supporting the price of Phase I allowances. However, the Commission views banking as a form of State aid and only allows it if it can be proven that the surplus is the result of successful emission reductions schemes that have been implemented. We believe that Frances and Polands surplus are the result of a rather generous

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assessment of base emission (ie over-allocation) and DSM due to high CO2 prices. Therefore it should prove quite a challenge for both countries to get a significant amount of Phase I allowances moved over to the 2008-12 period. While this further boosts the price for Phase II allowances, it also increases the chances that Phase I allowances will eventually drift toward zero.

Impact on the power price plays

As far as the power price plays in the sector are concerned, Phase I is of little consequence now as the vast majority of 06 and 07 output has been sold long ago. On the other hand the revival of Phase II allowances presents a welcome boost to the earnings outlook. While there remains considerable uncertainty over the direction Phase II allowances will be heading (GDP growth, weather, DSM, fuel prices, actual supply of CDMs/JIs) last Wednesdays rulings have ensured that Phase II allowances move towards the mid-range of plausible scenarios. This should benefit the power price plays in the sector as they sell output for 08 and beyond.

CO2: gap between Phase II and Phase I allowances widens

(/tonne) 35 30 25 20 15 10 5 0 11/9/2004
Source: Reuters

2/17/2005

5/28/2005

9/5/2005

12/14/2005

3/24/2006 EUA 08

7/2/2006

10/10/2006

1/18/2007

EUA 07

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Disclosure appendix
Disclosures under US regulations
Dresdner Kleinwort or an affiliate is broker to awg, United Utilities and Drax in the UK. Dresdner Kleinwort or an affiliate is financial advisor to awg, United Utilities and Scottish & Southern in the UK. Dresdner Kleinwort or an affiliate makes a market in Severn Trent, awg, National Grid, Kelda, ScottishPower, Centrica, United Utilities, Pennon, Scottish & Southern, International Power, Viridian, British Energy and Drax. A current or former member of the Supervisory Board or Board of Managing Directors of Allianz AG or Dresdner Bank AG or an employee of Dresdner Bank AG and/or its subsidiaries is a member of Aufsichtsrat of RWE. A current or former member of the Supervisory Board or Board of Managing Directors of Allianz AG or Dresdner Bank AG or an employee of Dresdner Bank AG and/or its subsidiaries is a member of Aufsichtsrat of E.ON. Dresdner Kleinwort or an affiliate managed, co-managed or was a syndicate member for a public offering of equity securities for Gaz de France and EDF in the last 12 months. Dresdner Kleinwort or an affiliate managed, comanaged or was a syndicate member for a public offering of debt securities for National Grid and Veolia in the last 12 months. Dresdner Kleinwort or an affiliate expects to receive or intends to seek compensation from Severn Trent, awg, EdP, RWE, Endesa, National Grid, Centrica, United Utilities, Gas Natural, Fortum, Scottish & Southern, Enel, E.ON, Veolia, Snam Rete Gas and EDF for investment banking services in the next three months. Dresdner Kleinwort or an affiliate has a beneficial interest in 1% or more of the equity of Severn Trent, RWE, Endesa, Kelda, ScottishPower, United Utilities, Iberdrola, Fortum, Scottish & Southern, Suez, Red Electrica, Enel, E.ON, Veolia, International Power, Snam Rete Gas and Terna. Dresdner Kleinwort or an affiliate regularly holds trading positions in the securities of Drax. Dresdner Kleniwort is advising AWG in connection with an offer by Osprey Acquisitions Limited. Dresdner Kleinwort or an affiliate has received compensation from RWE, National Grid, United Utilities, Scottish & Southern, E.ON, Veolia and EDF for non-investment banking securities services in the past 12 months. Dresdner Kleinwort or an affiliate has received compensation from RWE, National Grid and E.ON for non securities services in the past 12 months. Dresdner Kleinwort or an affiliate has received compensation from awg, National Grid, United Utilities, Scottish & Southern, Red Electrica, Enel, Veolia and EDF for investment banking services in the past 12 months. Dresdner Kleinwort or an affiliate regularly holds trading positions in the shares of Severn Trent, awg, EdP, RWE, Endesa, National Grid, Kelda, Centrica, United Utilities, Pennon, Gas Natural, Iberdrola, Union Fenosa, Fortum, Scottish & Southern, Suez, Red Electrica, Enel, Aguas de Barcelona, E.ON, Veolia, International Power, Viridian, Enagas, Snam Rete Gas, Gaz de France, Northumbrian Water, Terna, British Energy and Drax. The relevant research analyst(s), as named on the front cover of this report, certify that (a) all of the views expressed in this research report accurately reflect their personal views about the securities and companies mentioned in this report; and (b) no part of their compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or views expressed by them contained in this report. Any forecasts or price targets shown for companies and/or securities discussed in this report may not be achieved due to multiple risk factors including without limitation market volatility, sector volatility, corporate actions, the unavailability of complete and accurate information and/or the subsequent transpiration that underlying assumptions made by Dresdner Kleinwort or by other sources relied upon in the report were inapposite.

Recommendation history charts

Past performance is not an indicator of future performance.

Dresdner Kleinwort Research Recommendation definition (Except as otherwise noted, expected performance over next 12 months)
Buy: Add: Hold: 10% or greater increase in share price 5-10% increase in share price +5%/-5% variation in share price Sell: Reduce: 10% or more decrease in share price 5-10% decrease in share price

Distribution of Dresdner Kleinwort equity recommendations as of 30 Sep 2006

All covered companies Companies where a Dresdner Kleinwort company has provided investment banking services (in the last 12 months)
58 27 9 94 20% 18% 13%

Buy/Add Hold Sell/Reduce Total

Source: Dresdner Kleinwort

292 148 71 511

57% 29% 14%

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The disclosures under US regulations above should be read together with these additional disclosures.

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