Capital outlook: power and utilities - EY

Capital outlook: power and utilities Investing in the power and utilities sector

| Capital outlook: power and utilities

ContentsWelcome to Capital outlook 1

Americas 4

Asia-Pacific 12

EMEIA 18

Japan 26

Notes and methodology 31

Globalcontacts 32

Capital outlook responds to requests from our clients for detailed data regarding current power and utilities (P&U) asset valuations, and for deep insight into the trends behind these valuations and the likely impacts on future transaction activity. This level of comprehensive data is needed now more than ever, to guide capital investment during one of the most challenging periods of our sector’s history.

The utilities sector is undergoing rapid transformation. Technology and digitization; infrastructure renewal and expansion; renewables and distributed generation; empowered customers; market and regulatory reforms; and new market entrants have created an environment of constantchange.Amidsuchmonumentalchange,itcanbedifficulttomake informed, strategic decisions about capital investment in the sector.

For the transmission and distribution (T&D) sub-sector, megadeals — particularly in the US — are pushing valuations to peak levels. We are seeingT&DassetsintheUStradingat15.2xontwo-yearforward(FY2)or2015consensusearnings-per-share(EPS)estimates—alevelabout25%abovethehistoricalaverage.Investorsarepreparedtopaypremiumsofbetween15%and35%fortheseassets,attractedbytheir ability to provide stable returns amid continuing commodity price volatility and electricity demand stagnation in mature markets. Expect toseeawaveofT&DdealsinAsia-Pacific,drivenbyforecasthighdemand growth, potential market reforms allowing private investment and relatively low valuations for these assets compared with other regions.

Meanwhile,thegenerationsub-sectorfacessignificantheadwindinmost regions, particularly in mature markets, due to low power prices, stricter environmental regulations for fossil-fuel-based plants and increasing competition from renewables. Integrated utilities, especially in the US, are selling these assets to focus instead on their regulated operations. Similarly, European utilities are reevaluating assets and shifting their attention to long-term sustainable businesses. We believe high-growth emerging markets, such as China, remain attractive

Capital outlook: power and utilitiesUsing data from multiple sources, this report examines the trends and drivers for global power and utilities transaction activity, highlighting those regions and sub-sectors we believe will be attractive to investors.

“Power and utilities” covers electricity generation, networks and retail, gas networks and retail, and water wholesale, networks and retail organizations. It also includes renewable energy companies.

For more information on the methodology employed in the preparation of this report, please contact Cara Graham, Director, Global TAS Power & Utilities.

Welcome

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

3Capital outlook: power and utilities |

to the first edition of Capital outlook: power and utilities

Key findings:• Transmission and distribution companies are trading

above average, driven by stable earnings and relatively high dividend yields, and attracting M&A premiums of up to35%.

• Generation and independent power producer valuations haveimprovedintheUS,butcompaniesinAsia-PacificandEMEIAaretradingata20%to30%discount.

• IntegratedanddiversifiedutilitiesvaluationsinEuropehave been hit hard and companies in the region are shifting their focus to the emerging markets.

• Renewables are attracting the most attention in the US, China, Germany and Japan where demand is strong and regulatory support is relatively solid.

Matt Rennie

Global Transaction Advisory Services

Power & Utilities Leader

targets for generation investment as fuel security improves and generation demand stays strong. Historically, base-load-independent power producers (IPPs) in China have traded at an average multipleof8.5xonFY2consensusearningsbeforeinterest,taxes,depreciation, and amortization (EBITDA) estimates, with this group currentlytradingata20%discounttothoselevels.

ForintegratedanddiversifiedutilitiesinEurope,slowdomesticgrowth and weak power prices have cut valuations and increased the push toward emerging markets such as Mexico, Brazil and Turkey, where reforms are opening up investment opportunities. Selective international investments and divestments of non-performing businessesindomesticmarketsmayunlocksignificantvalueforintegrated utilities in mature markets.

The renewables sub-sector is facing a drop in valuations and challengestogreenfieldprojects,particularlyinmaturemarketssuch as Europe and the US. The UK and Germany are slowly phasing out their feed-in tariffs (FITs) for solar generation, while other countries, including Spain and the Czech Republic, have abruptly halted these incentives altogether. Still, the rapid decline of costs continuestodriverenewablestowardgridparity,andnewfinancingstructures such as yieldcos — publicly-traded companies that include predictable operating assets with power purchase agreements (PPAs)thatproducecashflow—aregaininginpopularity.Yieldcostypicallyoffer5%to6%dividendyieldandtradeatasignificantpremium to traditional P&U companies. For example, NRG Yield Inc. (aUS-basedyieldco),tradesatabouta50%premiumtoitsparentNRG Energy, Inc. (a US-based IPP).

Itcanbedifficulttomonitorthediverseandfast-changingsetofeconomic, political and social conditions that impact on utilities valuations — let alone understand and capitalize on these complex drivers. Capital outlook cuts through this complexity, using the experienceofourglobalnetworkofmorethan700seniorclient-facing P&U professionals, to make sense of key valuation trends.

Using a series of detailed multiples and valuation metrics, thisreportistailoredspecificallyfortheP&Usector.WewillupdateCapital outlook every six months to highlight the areas and sub-sectors we consider to be the most likely source of transaction activity over the short to medium term. In this way, whether you are buying, selling or considering a shift in the focus of your capital agenda, we hope that this provides a reference and guide for trends, metrics and comparisons.

We look forward to your feedback and encourage you to please get intouchwithyourlocalcontact(listedonpage32)todiscussyourown capital agenda goals.

4 | Capital outlook: power and utilities

Global risk/reward valuation profile

USSub-sector focus: T&D (northeast region) Renewables (southwest region)

MexicoSub-sector focus: Generation (post reforms)

BrazilSub-sector focus: Renewables (wind)

NigeriaSub-sector focus: Generation, renewables

Saudi Arabia Sub-sector focus: Generation


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Global risk/reward valuation profile

Japan

Notes on framework:

• The valuation represents current levels versus historic group levels for the sub-sector

• Risk/reward is based on volatility of earnings and expected risks for the sub-sector

IndiaSub-sector focus: Renewables, generation

ChinaSub-sector focus: Generation (local players to acquire smaller companies)

AustraliaSub-sector focus: T&D

JapanSub-sector focus: Renewables Retail (post reforms)


Section 1

Americas While valuations for most of the region’s companies, especially in the US, remain at near-historic highs, low interest rates and an improving commodities outlook should see asset valuations in some sub-sectors rise even higher. For many US utilities, the significant capital requirements of complying with new US Environmental Protection Agency (EPA) regulations continue to have an impact. And while regulated utilities are likely to pass these investments onto ratepayers, expect to see many merchant generators continue to retire coal-fired plants, rather than fund costly retrofits.

1.1 Transmission and distribution Valuation dataSince2007,regulatedT&DutilitiesintheUShavetradedatanaverageprice-to-earnings(P/E)multipleof12.3xonFY2EPS,between the range of 7.8x to 15.9x. However, the group is currentlytradingatanaverageof15.2xonFY2EPS,implyinga25%premiumtohistoricalaverages.Webelievefurthermultipleexpansion for the regulated group is unlikely for the reasons outlined in the Valuation drivers section.

Based on M&A deals in the US over the last two to three years, transaction multiples imply that investors are willing to pay a15%to35%premiumforthesecompaniesovercurrentgroup valuations. Despite the stretched valuations, we believe consolidation will continue as T&D companies look to acquire assets to increase their rate base amid declining demand growth and returns. While much of the Southeast is already consolidated, we consider the Northeast to be well-placed for consolidation due to the presence of many small- to mid-cap utilities.

Figure 2: Transaction P/E multiples for major M&A deals,since 2012

Format: Target/Acquirer (announcement date). Transaction multiple calculated using price paid and FY2 earnings estimates for targets

17.4x 18.1x20.8x

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NV Energy/BerkshireHathaway (May 2013)

UNS Energy/Fortis (Dec 2013)

Pepco/Exelon (Apr 2014)

IntegrysEnergy/

Wisconsin Energy (Jun 2014)

P/E

Figure 2: Transaction P/E multiples for major M&A deals, since 2012

Figure 1: Average P/E trading multiples on FY2 consensus earnings estimates

Regulated T&D companies in the US are currently trading at the high end of the historic range

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Source: S&P Capital IQ, EY Analysis

P/E

Figure 1: Average P/E trading multiples on FY2 consensus earnings estimates, 2007-14

Source: S&P Capital IQ, EY analysis Source: S&P Capital IQ, EY analysis

Format: Target/acquirer (announcement date). Transaction multiple calculated using price paid and FY2 earnings estimates for targets.


Valuation driversRising interest rates provide headwinds for utility valuations: WhiletheUS10-yearTreasuryyieldbottomedoutinmid-2012atanaveragenear1.5%,ithassinceincreasedbyapproximately75%toaveragenear2.5%.Thistrendofincreasingyieldwillputpressure on regulated utilities’ valuations, given the declining attractivenessofdividendlevels,whichaveragenear4%to5%.

Significant rate base growth opportunities for T&D businesses: T&Dcapitalexpenditure,whichaccountsfornearly50%oftheplanned spending by electric utilities over the next three years, is expected to remain relatively steady. T&D infrastructure investments are driven by the need to:

• Replace aging infrastructure

• Connect the increasing renewable capacity to the grid

• Modernize the existing grid to incorporate smart meters

• Improve the overall reliability of the system

Additionally, despite challenges to the rates of return authorized by the Federal Energy Regulatory Commission (FERC), the level of return allowed for transmission investment remains higher than returns authorized by state commissions (which regulate distribution businesses) in traditional proceedings. Pure-play transmission companies such as ITC Holdings Corp. trade at a 15%to20%highermultiplethanotherregulatedutilities.Confidenceintheseregulatedbusinessesisdrivenbytheirrelatively stable earnings and solid dividend yields.

Weak demand, declining allowed returns and increasing regulatory challenges weigh on earnings: As shown in Figure 3, the allowed returns for US regulated utilities are on the decline. This, combined with the current environment of weak electricity demand growth, means that utilities will face bigger challenges in passing on capital investment costs to ratepayers. However, new constructive regulatory policies that aim to help utilities better recover their true costs, such as the Reforming Energy Vision under consideration in New York state, are likely to become more commonplace.

Figure 3: Allowed returns (RoE) for regulated electric and gas utilities in the US, 1998–2013

Source: SNL Energy, EY Analysis

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Figure 3: Allowed returns (ROE) for regulated electric and gas utilities in the US, 1998-2013

Source: SNL Energy, EY analysis


Valuation dataHistorically, base-load-IPPs in the Americas have traded at an averageof8.2xonFY2EBITDAforecasts,asshowninFigure4.The2008economiccrisissawIPPvaluationsdropsignificantly,whilethe2012declineofUSnaturalgasandpowerpricesprompted another, smaller, dip. Valuations have since improved, withcurrenttradingmultiplesnearing9.2x.

The last few years have seen many asset-level generation deals whereIPPsandotherfinancialinvestorshaveacquiredbase-loadplants,mostlyfromdiversifiedutilities,aslownaturalgasand power prices saw many discounted power plants come to market.Diversifiedutilities,ontheotherhand,havefocusedonoptimizing assets and growing their regulated businesses.

Valuation drivers Improving commodity outlook will drive valuations higher: As shown in Figure 5, US natural gas prices have rebounded significantlysincetheirmid-2012lowoflessthanUS$2/MMBtu.Currentforwardprices,asshowninFigure6,indicatethatnaturalgaswillreachnearUS$4.6/MMBtuby2020,implyinganincreaseofapproximately15%to20%fromcurrentlevels.Sincenaturalgasprices drive the power prices in most states, this trend of increasing prices is set to improve the valuations for conventional sources of generation.

New environmental regulations weigh on the future of coal capacity: Based on industry estimates, power companies in the USplantoretirenearly28GWofcoal-firedgeneratingcapacity

1.2 Generation and independent power producers

Figure 4: Average EV/EBITDA multiples for IPPs on FY2 consensus estimates


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Figure 5: Natural gas day-ahead prices, Henry Hub,last 3 years, US$/MMBtu

Source: SNL Energy

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Figure 4: Average EV/EBITDA multiples for IPPs on FY2 consensus estimates, 2007-14

Figure 5: Natural gas day-ahead prices, Henry Hub, US$/MMBtu, 2011-14

Source: S&P Capital IQ, EY analysis Source: SNL energy


between2014and2022,withthemajorityoftheseretirementsplannedintheMidwestregion.In2013,about6.3GWofcoal-firedgenerationwasretired,withnearly2.8GWofadditionalcapacityexpectedtoberetiredbytheendof2014.Whilethis2014numbermayseemrelativelylow,themajorityofplannedshutdownsareslatedtooccurin2015,whentheMercuryandAirToxicsStandards(MATS) rule takes effect. Other regulations, including the EPA’s long-awaitedproposedcarbonregulationandtherecentlyfinalizedCooling Water Intake Structures rule, provide further incentives to retirecoal-firedplants.

Valuation for assets will increase in tighter power markets: Resource adequacy in regions such as Texas (managed by the Electric Reliability Council of Texas (ERCOT)) and the Midwest (managed by the Midcontinent Independent System Operator (MISO)) will fall below reserve margin targets within the next few years. For example, ERCOT is expected to remain below the target reservemarginsoverthenext10-yearperiod,whileMISOwillfallbelowtargetsduringthe2015summerseason.Inthisscenariooflow capacity availability, we expect power prices to spike, improving the economics of existing plants.

Figure 6: Natural gas average yearly forward prices,Henry Hub, 2014–2020, US$/MMBtu

Source: SNL Energy

$3.94 $3.95$4.08

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Figure 6: Natural gas average yearly forward prices, Henry Hub, 2014-20, US$/MMBtu

Source: SNL energy


Valuation dataIntegratedanddiversifiedutilitiesintheAmericashavetradedatanaverageof7.9xonFY2EBITDAforecasts.Afterhittingalowof5.7xin2009,theseutilitieshavereboundedwithcurrenttradingmultiplesnearing9.0x.

The move to increase exposure to regulated earnings, through divestiture of merchant plants or acquisitions of regulated assets, is driving valuations higher for these companies. However, higher long-termvaluations,especiallyforcompanieswithsignificantleverage to power markets, depend on the upside for natural gas prices from current levels.

Valuation driversTherecenttrendofUSdiversifiedutilitiessellingtheir non-regulated power plants, in order to focus solely on regulated businesses,isre-settingtheirtradingmultiples.In2013, Missouri-based Ameren Corp. sold its merchant coal plants to Dynegy while California-based Edison International sold its non-regulated subsidiary, Edison Mission Energy. Other large caps, including Duke Energy and American Electric Power, have announced sales of Midwest power plants.

Diversifiedcompanies,whicharesignificantlyleveredtogenerationbusinesses, are acquiring regulated utilities to de-risk their asset bases. A notable example is PPL Corp. The company’s acquisitions of regulated utilities in the US and UK over the last few years have transformeditsbusinessmixfrom80/20merchant/regulatedtoa20/80ratio.Also,thecompanyrecentlyannouncedplanstospin off merchant assets into a separate IPP, making PPL a purely regulated company. Similarly, Exelon Corp. recently acquired Pepco Holdings, a regulated utility, in a move that will see regulated operationscontributingabout60%to65%ofExelon’stotalearningsover2015-16(upfromexpectationsof55%to60%pre-deal).

1.3 Integrated and diversified

Figure 7: Average EV/EBITDA trading multiples on FY2 consensus estimates


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Figure 7: Average EV/EBITDA trading multiples on FY2 consensus estimates, 2007-14

Source: S&P Capital IQ, EY analysis


Valuation driversA number of factors are currently impacting the availability of new renewableprojectsintheUS,including:

Renewable Portfolio Standards (RPS): RPS, adopted by many US states,1 support long-term demand for renewable energy, although capacity requirements vary across states, and some are voluntary rather than mandated. For example, California requires its utilities toderive33%oftheirretailelectricitysalesfromrenewablesourcesby2020—thehighestpercentageofanystate.However,existingstate RPS programs require annual renewable energy additions of only3GWto5GWperyearbetween2013and2020,lowerthantherecent annual renewable additions.

1.4 Renewables

Valuation dataMost M&A deals in this sub-sector involve assets. Valuations vary widely depending on the type of renewables technology and the projectstage(i.e.,planning,constructingoroperating).IntheUS, thetransactionmultiplesforwindprojectsacquiredoverthelast fewyearsaveragedaroundUS$700/kWtoUS$750/kW.

Historically, as shown in Figure 8, wind deals dominated the overall M&A landscape in the US renewables sub-sector although activity within solar has recently picked up. While wind capacity under construction is currently low — driven down by the end of certain tax credits — new solar capacity could keep M&A momentum high, as shown in Figure 9.

1TheadoptionofRPShasbeenmandatedin29states–Arizona,California,Colorado,Connecticut,Delaware,Hawaii,Illinois,Iowa,Kansas,Maine,Maryland,Massachusetts,Michigan, Minnesota,Missouri,Montana,Nevada,NewHampshire,NewJersey,NewMexico,NewYork,NorthCarolina,Ohio,Oregon,Pennsylvania,RhodeIsland,Texas,Washington,Wisconsin– andtheDistrictofColumbia.Thestandardshavebeenvoluntarilyadoptedbyanadditionaleightstates–Indiana,NorthDakota,Oklahoma,SouthDakota,Utah,Vermont,Virginia,andWestVirginia.

Figure 8: M&A deal count in the US, by technology


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Figure 9: Renewable capacity under constructionin the US, MW


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Figure 9: Renewable capacity under construction in the US, MW, 2012-15E (estimated)



Tax credits:ProductionTaxCredits(PTC)expiredin2013,creating uncertainty for the development of new renewable projects,especiallywind-basedprojects.InvestmentTaxCredits(ITC), used mostly by solar developers, are scheduled to expire by2016.LimitedfundingavailabilityremainsakeyconstraintfortheindustryintheUS,drivenbyexpirationofthe1603Treasurycash grants, limited availability of tax equity in the market and decliningventurecapitalinvestments.Despitethesedifficulties,the entry of non-traditional tax-equity players such as utilities and technology companies, as well as the introduction of possible new investment vehicles (such as master limited partnerships and reverse auction mechanisms) could help offset the limited availability of capital in the market.

Levelized cost of energy (LCOE): LCOE for renewables is decreasing fast as technology improves. However, low natural gas and power prices are still weighing heavily on this sub-sector’scashflowandreturns,especiallyforsolarprojects. AftertoppingoutatnearlyUS$70/MWhin2009,theaveragelevelizedlong-termpriceforwindPPAssignedin2011-12felltoaroundUS$40/MWhintheUS,almostmatchingthelowsof2000–05,whichisnotableconsideringthatinstalledprojectcostshave not returned to the levels of this period. We are seeing wind PPA prices generally lowest in the interior region, highest in the west and somewhere in the middle everywhere else.

Carbon regulations: A potential introduction of carbon tax in the US could drive further growth for renewables. The recently released EPA draft regulations for carbon dioxide emissions by coalplantsproposea30%reductioningreenhouseemissions intheUSby2030,aswellasMexico’snewcarbontax (introducedinJanuary2014),looksettoboosttherelative cost-competitiveness of renewable energy in the region.

Figure 10: Number of M&A deals by sub-sector in theAmericas, 1Q13–1Q14

Source: Mergermarket data and EY analysis

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Figure 10: Number of M&A deals by subsector in the Americas, 1Q13-1Q14



Over the past few years, low natural gas and power prices have seenmanyUSdiversifiedutilitieslookingtoselltheirnon-regulatedplants, creating a pipeline of discounted assets. Pure-play IPPs, especially in the US, have acquired most of these assets, with the expectation that energy and capacity prices will increase in the long term. As US regulated businesses continue to attract megadeals, we expect focus to shift to Northeast natural gas companies where infrastructure bottlenecks still exist.

The US and Brazil are the most active M&A destinations in the Americas,intermsofdealvolume,overthelast12-months.Therenewables sub-sector is most active in terms of deal volume, with significantinterestinwindandsolartechnologies.

Our expectations regarding the capital outlook for the Americas appear in Map 1.

Map 1: Key trends in the Americas capital outlook

1.5 The capital outlook: Americas

New renewable capacity will continue to drive M&A in the US. While California leads in terms of capacity under development, other states including North Carolina, Florida, Kentucky and Nevada also maintain a healthy pipeline.

Mexico’s recent energy reforms, including opening the electric generation sector to full private participation and investment, marks a fundamental change from the previous regime. Asstate-ownedutilityCFEundergoesmajortransformation, we expect it to shed multiple assets. The introduction of retail competition for Mexico’s largest customers also provides investment opportunities.

Acquisitions in the renewable energy space in Brazil are expected to heat up as the country’s windportfoliomovesfromconstructionprojectsto developed assets. Further, after agreeing to sell power at record low rates in the recent auctions, wind farm developers will need scale to remainprofitable,whichinturnislikelytodriveM&A in the sector.

Themajorityoftheintegratedutilitiesinthe US are looking to divest their merchant generation businesses, to reduce exposure to natural gas price volatility. The Midwest region in particular has seen most of the assetsales.MajorcompanieslikeEdisonInternational, Ameren Corp., Duke Energy, American Electric Power and PPL Corp. have sold or have announced the sale of their non-regulated plants.

Following last year’s market reform, utilities in Brazil are reconsidering their strategies and rebalancing portfolios. Electrobras, Brazil’s state-run utility, reported losses in itsquarterlyandannualresultsin2013,andhas embarked on a restructuring program. The company is seeking approvals from the government to sell its six distribution units, whichlostacombinedR$1.33b(US$587m)in2012.Weanticipatetheseassetstocometothemarketin2014.

Figure 11: Average P/E multiples on FY2 consensus estimates


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Figure 11: Average P/E multiples on FY2 consensus estimates, 2010-14


Figure 12: Electricity demand growth (year-on-year) by region, current policies scenario, 2011–2035

Source: International Energy Agency (IEA)

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Figure 12: Electricity demand growth (year-on-year) by region, current policies scenario, 2011-35

Source: International Energy Agency


Section 2

Asia-PacificValuations for utilities in Asia-Pacific are attractive compared with other regions, especially in the generation sub-sector. Asian P&U companies benefit from strong demand and the potential introduction of positive regulatory reforms. China leads in terms of M&A activity, with significant deals in both the generation and renewables sub-sectors.

Valuation dataSince2010,keyT&DutilitiesintheAsia-PacifictradedatanaverageP/Emultipleof13.5xonFY2EPS,intherangeof11.5xto15.0x.Thegroupiscurrentlytradingatanaverageof14.0xonFY2EPS,implyingamodestpremiumof4%onhistorical averages.

2.1 Transmission and distribution

Valuation driversA number of key factors are impacting the valuations of T&D assets inAsia-Pacific:

High demand growth supports earnings growth: Electricity and gasdemandintheAsia-Pacificwillcontinuetogrow,largelydrivenbyaboveaverageGDPgrowthintheregion.AsshowninFigure12,Asianutilitiesareexpectedtoface,onaverage,4%year-on-yeargrowthinelectricitydemandthroughto2035.

Reforms in key countries such as Australia and China will present long-term investment potential for investors.


Specifically:

• Increased regulatory visibility in Australia. As per Moody’s Investors Service, the outlook for the Australian regulated networksindustryiscurrentlystable.Thisratingreflectstheincreased visibility of the process by which networks’ revenue is determined, based on details recently released by the Australian Energy Regulator regarding its new rate-of-return framework. In addition, the New South Wales and Queensland Governments in Australia have announced plans to privatize their transmission and distribution assets.

• Potential reforms to break monopolies in China.In2014, China’s National Energy Administration submitted plans to the State Council, advising the break up of grid operators’ monopoly in the distribution and retail of electricity. These reforms will potentially open the power market to private capital and other investments.

• Incremental capital spending opportunities will drive earnings higher. Regulated companies, deriving their earnings from the returnsoninfrastructurecapitalspending,willbenefitfromgrowing demand. For example, high growth in China is leading the country’s largest state-owned utility, State Grid Corporation of China, to build eight new ultra-high-voltage lines between 2013and2021,atanestimatedcostofmorethanUS$150b.

Figure 13: Average EV/EBITDA multiples for Chinese IPPs on FY2 consensus estimates


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Figure 13: Average EV/EBITDA multiples for Chinese IPPs on FY2 consensus estimates, 2010-14



Valuation dataCurrentmultiplesformajorgenerationcompaniesinthe Asia-PacificaremostlydominatedbylargeChinesecompanies.Historically, the base-load-IPPs in China traded at an average of8.5xonFY2EBITDAforecasts,asshowninFigure13. The valuations for these companies have declined steadily since 2010,andthegroupiscurrentlytradingatabout7.0x,implyingadiscountofapproximately20%tohistoricaverages.Theselowvaluations create investment opportunities for larger IPPs to expand their market share by acquiring the under-valued smaller players.

InAustralia,AGLEnergyLimitedannouncedinFebruary2014that it would acquire Macquarie Generation from the Government ofNewSouthWalesforaboutUS$1.4b—implyingaEV/EBITDAmultipleof6.7xonlastfull-yearEBITDA.Whilethedealwasthesubjectofsignificantregulatoryscrutinyonanti-competitivegrounds, the Australian Competition Tribunal cleared the sale inJune2014.

Valuation drivers KeyfactorsimpactinguponAsia-Pacificvaluationsinthissub-sectorinclude:

Higher generation output driving earnings higher in select countries: IPPs, especially in China, continue to witness strong growth in generation output. For example, Huaneng Power International, a large-cap thermal power IPP based in China, disclosed that the company’s total power generation within China amountedto317.5bkWh,representinganincreaseofabout5%over the same period last year. The increase was largely driven by the stable growth of the nationwide electricity consumption, above-normal summer temperatures and increased sales efforts.

Declining commodity prices favor margins but potential tariff cuts loom: In China, the thermal coal price has stabilized at low levelsofaroundRmB535(US$87)/ton,withnoindicationofanysignificantupwardmovement.However,theNationalResourcesDefense Council of China (NDRC) has a price link mechanism between coal and electricity prices, which lifts tariffs if the thermal coalpricerisesmorethan5%overtheyearandreducestheIPPs’cost-bearingratioto10%(versus30%previouslyused).Whilethis mechanism does provide better earnings visibility for IPPs by allowing them to pass on costs to grid companies, the current environment of declining coal prices is likely to mean lower tariffs for Chinese IPPs.

Overhang of potential carbon tax: The Chinese Government plans to implement a tax on carbon emissions in addition to a planned emissions trading scheme. However, to date, neither of these proposals has been clearly outlined. And while coal-based Chinese IPPs continue to face this overhang of a potential carbon tax regime, the Australian senate recently voted to remove that country’s carbon tax.

Threat of over-capacity:Between2000and2011,electricitygenerationinChinagrew,onaverage,by12%year-on-year,beforefallingtolessthan6%growthin2012.Despitethismoderationindemandgrowth,Chinaispushingaheadwithplanstoaddsignificantnew thermal and renewable capacity, which may result in a miss-match in demand and capacity additions that could weigh on future valuations for this sub-sector.


Figure 14: Average EV/EBITDA trading multiples on FY2 consensus estimates


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Valuation dataSince2009,keyintegratedanddiversifiedutilitiesintheregionhavetradedatanaverageEV/EBITDAmultipleof8.2xonFY2estimates,betweentherangeof7.0xto9.6x.Thegroupiscurrentlytradingatanaverageof7.4xonFY2estimates,whichisnear the low-end of the range.


Valuation driversThis sub-sector is exposed to the same valuation drivers as regulated utilities and power producers. The valuation differences between these companies is driven by the level of exposure to the regulated versus merchant businesses, and the overall macro-economic environment of their respective countries.

Figure 15: Renewables deal volume and value for Asia Pacific


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Figure 16: Expected solar PV system prices, US$/Watt, 2010-20


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2.4 Renewables

MostAsia-Pacificgovermentsarecontinuingthepushformorerenewableprojects.Whileoveralldealflowhasbeenlowerthanexpectedoverthelast12months,weseepositivesignsinseveral countries regarding new construction by local generators. International developers are also increasingly attracted to local projects,primarilytotakeadvantageofgovernmentandmarketincentives, as well as the increase in the region’s overall electricity demand.

• Declining costs of technology increases attractiveness for renewables: The costs of renewable technologies, especially solar PV, have declined drastically over the last few years. Solar PV moduleunitcostshavefallenbyover75%since2006.AsshowninFigure16,systempricesareexpectedtodropevenfurtherinthefuture.

• Anti-dumping duties impact manufacturing companies: In2011-12,theUSfiledacasewiththeWorldTradeOrganization(WTO) that claimed China’s anti-competitive subsidies were supporting solar sector growth. The case was followed, in June 2014,byanannouncementbytheUSDepartmentofCommercethat imports of Chinese solar panels would now attract preliminary dutiesof18.56%to35.21%.ThedecisionmaycausefinancialdifficultiesforChinesesolarmanufacturers,especiallyconsideringthat some have already defaulted on previous debts, mostly due to over-ambitiousexpansionplans.In2013,SuntechPowerdefaultedonUS$541mofconvertiblebondswhileLDKSolaralsodefaultedon an equally large bond that matured.

Valuation driversA number of factors are currently impacting the development and valuationsofnewrenewableprojectsinAsia-Pacific,including:

• Renewable targets support continuing growth: While Asia-Pacificislargelystilldependentonfossilfuels,thefocusonrenewable energy is increasing fast. Most countries in the region haveatargetofaround20%renewableenergyby2020,withrenewablescurrentlygeneratinglessthan15%oftotalproductionon average. An exception to this average is seen in New Zealand, whichalreadysourcesmorethan75%ofitselectricityneedsfromrenewable energy, mostly through hydropower and geothermal energy.NewZealandaimstomeet90%ofitselectricityneedsthroughrenewablesourcesby2025.


2.5 The capital outlook: Asia-Pacific

ChinacontinuestodominateinboundM&AdealswithinAsia-Pacific’sP&Usector,withmorethan50%oftheregion’sdealstakingplaceinthatcountry over the past year. Most transactions are in the renewables and generationsub-sectors.Elsewhere,dealflowforrenewableenergyprojects

in Southeast Asia have improved over the last year, with notable solar projectsinThailand,thePhilippinesandMalaysia,andgeothermalprojectsinIndonesia.OurexpectationsregardingthecapitaloutlookforAsia-PacificappearinMap2.

Map 2: Key trends of the Asia-Pacific capital outlook

InMarch2014,China’sNationalEnergyAdministration (NEA) submitted a new plan to the State Council for reform of the country’s power sector. Under the proposed reform, grid operators will gradually withdraw from electricity sales, allowing large-end users to purchase electricity directly from power producers at prices negotiated freely. Several provinces, such as Hunan, Sichuan, Shanxi and Gansu, have already begun to pilot direct power purchase for large users, with NEA publicizing the average power transmission and distribution cost bymonitoring10provincialpowergrids.

Australian infrastructure funds are continuing to increase their presence within P&U. Macquarie is reportedly looking to expand its portfolio of power assets and invest in continentalEurope,whereutilitiesareclosingsignificantgasandcoaldeals.Cheapdistressedgenerationassetsareontheshoppinglistoffinancialinvestors,whoforeseeprofitsonceEuropeanenergysupplyandregulatoryconcernsareclarified.

Privatization of the sector in New Zealand and Australia is progressing. The New ZealandGovernmenthasannounceditwillsellupto49%ofGenesisEnergyinasaletippedtogenerateasmuchasUS$684.5m.Followingthesaleofitsgenerationassets, the New South Wales Government has announced that it will enter into a long-termleaseof49%ofthestate’snetworkassets.Similarly,theQueenslandGovernment has also foreshadowed plans to privatize the state’s generation and network assets.

Case study: Envestra, the Australian natural gas retailer, recently announced its takeover by a consortium comprising Cheung Kong (Holdings) Limited, Cheung Kong Infrastructure (CKI) and Power Assets (PAH). The deal involves a cash consideration of A$1.32(US$1.23)/share (atotalofA$1.96b(US$1.81b)aftertakinginto account CKI’s current 17.46%stakeinEnvestra),whichrepresents11xto12xEV/EBITDA.


Section 3

EMEIA

3.1 Transmission and distributionValuation dataSince2010,keyT&DutilitiesinEMEIAhavetradedatanaverageP/Emultipleof11.1xonFY2estimatedEPS,betweentherangeof9.2xto14.7x.However,thegroupiscurrentlytradingatthe high-end of the range (near 14.7x), implying a premium of approximately35%tohistoricalaverages.Webelievethatanyfurther increases in the P/E ratio are unlikely.

Valuation driversMarket reforms and regulatory changes have had the biggest impact on valuations in this sub-sector. EMEIA’s regulatory environment is dynamic, with many countries focusing on opening their power sectors to competition and private investments. Key country updates include:

• Saudi Arabia: The Saudi Government is planning to restructure the country’s leading electricity company, Saudi Electricity Company(SEC),intofourfirmsoverseeingelectricitygeneration,transmission, distribution and supply separately. In addition, in a bid to include private investors in the electricity development, the SEChasalreadytenderedfiveplantsusingtheIPPmodel,whichrequires the utility to enter into a take-or-pay agreement with the developer.

• Israel:Between2015and2018,theIsraeliGovernmentplanstosellupto15%ofitsstakesinstate-ownedelectricityutility,IsraelElectric, in a bid to reduce debt and boost competition.

• Tanzania:InMay2013,Tanzania’sMinisterofEnergyandMinerals, Professor Sospeter Muhongo, announced plans to restructure the state-owned electric utility, TANESCO, by unbundling it into separate generation, transmission and distribution companies.

• Greece:EnergyreforminGreecewillresultinthesaleof30%ofthe installed generation capacity of Public Power Corporation (PPC),thesaleof66%oftheIndependentPowerTransmissionOperator (ADMIE) and the sale of government’s minority stake of PPC.

The EMEIA region’s inclusion of both mature and emerging economies means selective opportunities are on offer for investors. For example, current valuations for T&D companies suggest that the sub-sector is over-valued, with limited upside from current levels. Meanwhile, generation companies, especially in Europe, are trading at significant discounts to their historical levels. Market reforms, such as the potential introduction of capacity markets and phase-out of financial incentives for renewables, should drive valuations higher.

Figure 17: Average P/E multiples on FY2 consensus earnings estimates, 2010-14


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Regulatorystabilitywillalsodrivecertaintyofcashflowsandreturnsinselectmarkets.Specifically:

• UK: Energy regulator Ofgem set new controls for electricity and gas transmission and distribution charges that came into effect fromApril2013underaframeworksettocontinueuntilMarch2021.Thesepricecontrolsarebasedontheassumptionthatequityinvestorsrequireatleasta6.7%to7.0%real-after-taxreturnontheirinvestment(plusinflation),andthatcompanieswhich outperform peers operationally should be able to earn incremental returns. However, Ofgem’s recent call to the Big Six retailers to explain to customers how falls in wholesale costs will impact bills indicates that the sector is not immune to political and regulatory pressures.

• India: India’s T&D segment is currently government-controlled, with the Power Grid Corporation of India (PGCIL) the country’s largest central transmission utility. An increase of tariffs in many statessince2012hasimprovedthehealthoftheStateElectricityBoards (SEBs) and provided momentum for higher realized returns for PGCIL. We anticipate that India’s newly elected and stable government, as well as expected power sector reforms, havethepotentialtoimprovecashflowsandreturnsforSEBsand transmission companies in the country.

Figure 18: Electricity demand growth (year-on-year) by region, current policies scenario, 2011–2035

Source: International Energy Agency (IEA)

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Valuation dataHistorically, the base-load-IPPs in the EMEIA region have traded at anaveragemultipleof8.4xonFY2EBITDAforecasts,asshownin Figure 19. The valuations for these companies have declined significantlyfroma2010highof12.5xto13.0xtonear9.0xlevels,adeclineofapproximately30%inmultiplelevels.

Valuation drivers Valuations in this sub-sector are currently impacted by diverse and dynamic factors:

The economics of natural gas generation in Europe are weak: Renewableenergysubsidiesandenergyefficiencygoalsacrossthe European Union are depressing power prices and impacting the margins of power generators. As the US faces an abundance of naturalgas,Europeisfloodedwithcheapcoal,which,inadditiontothe rise of renewables, has reduced demand for gas.

Closure of nuclear capacity impacts Germany and Belgium: According to the European Commission’s report EU Energy, Transport and GHG Emissions: Trends to 2050, net European nucleargeneratingcapacitywas131.3GWin2010,willdeclineto96.9GWin2025andwillriseto122GWin2050.Thedeclineto2025islargelyduetophase-outpoliciesinGermanyandBelgium.InBelgium,wherenuclearcurrentlyrepresentsabout30%oftotalcapacity,aphase-outplanwilltakeout6GWofnuclearcapacityby2025.Meanwhile,plantscurrentlyclosedfortestingarefacingbarriers to planned restarts.

Fuel supply security may increase confidence in emerging markets: For countries such as India, that depend heavily on imported fuel, availability of fuel is a key factor in valuations. For example, recent measures taken by National Thermal Power Corporation (NTPC), India’s largest IPP, to lock in a stable coal supply are seen as a positive sign for the company. NTPC is developingmultiplecoalblockswiththefirstcoalmine(Pakri-Barwadih) likely to be operational very soon. The company also has theflexibilitytoincreaseimportedcoalblendingfromcurrentlevelsand source coal via e-auctions. However, the recent decision by the Supreme Court of India to scrap nearly all coal block allocations previously allocated to power companies creates some uncertainty.

MultiplesformajorgenerationcompaniesintheareaaremostlydominatedbylargecompaniesinIndia,ItalyandSpain.

Figure 19: Average EV/EBITDA multiples on FY2 consensus estimates, 2010-14


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New environmental regulations impact the future of fossil fuel-based capacity:EUcountriesarecurrentlyboundbythe20-20-20energygoalsintroducedin2007.Thesegoalsstipulatethat,bytheyear2020,theregionmustachievea20%reductionincarbondioxideemissionsanda20%increaseinenergyefficiency,ascomparedtoa1990baseline.Inaddition,20%ofoverallenergymust be supplied by renewable energy sources. The long-term goal is80%decarbonizationbytheyear2050.

Potential new reforms protect conventional generation: The possible introduction in key European countries of long-term capacity remuneration markets, a well-known mechanism in the US, will provide additional incentives for base-load power capacity. InJune2014,Germany’sEconomyMinisterannouncedplanstointroduce a market for spare power capacity, aimed at helping loss-makingcoalandgas-firedpowerstationsstayopenasbackupfor wind and solar plants.

Figure 20: Average electricity generation growth (year-on-year) in key EMEIA countries, %, 2011–2015 average

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EMEIAishometosomeoftheworld’slargestP&UcompaniesandmostEuropeandiversifiedutilitiesoperateglobally.

Valuation data Europe’sdiversifiedutilitiesarecurrentlyfocusedonsellingnon-coreassetsandcuttingcosts.Post-financialcrisis,Europeanutilitieswere hit hard by declining energy demand, uncertain policies, over-leveraged balance sheets and a mandate to unbundle. These factors pushed utilities to divest assets, particularly regulated grids, which attractedsignificantpremiums.E.ON,RWEandGDFSuezemergedasthemostaggressivesellers.InMarch2014,RWEsolditsoilandgasunitforabout€5b(US$6.7b),aspartofits€7b(US$9.4b)divestiture plan aimed at funding new investments or paying down debt.SomeofE.ON’slargestrecentdivestmentsincludethe€2.8b(US$3.7b)saleofOpenGridEurope,thesaleofa50%stakeintheHorizonnuclearprojectandthe€1.3b(US$1.7b)stakesaleinSlovakian energy company SPP.

Large integrated utilities in EMEIA, dominated by European companies,arecurrentlytradingat7.8xonFY2EBITDAestimates—approachingthehighestlevelsofthepastfivetosevenyears.



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Valuation driversThis sub-sector is exposed to most of the valuation drivers for regulated utilities, as well as those affecting power producers. Key factors include:

Geographical diversification into high-growth areas: Expansion into high-growth markets is critical for large integrated companies currently pressured by struggling domestic economies and low power prices. Notable examples of this expansion include:

• Plans by Iberdrola SA, Spain’s largest integrated utility, to invest aboutUS$5binMexicooverthenextfouryears,encouragedbybroad reforms in that country’s energy industry.

• Announcements by Enel, Italy’s largest utility, that it will cut costs at home and focus new investment in emerging markets and renewableenergy—thecompanyplanstoinvestabout€25.7b(US$34.4b)over2014-18,ofwhich57%willbespentingrowthmarkets.

Relative attractiveness of dividend yields versus current interest rates: Investors in the traditional utilities sector typically look for sustainable dividends and high yields. These yields are now even more attractive, especially in Europe, given the sluggishness oftheEurozoneeconomicrecovery.InJune2014,theEuropean

CentralBanklowereditsmaininterestrateby10basispointstoahistoriclowof0.15%tospurgrowthandinflation.AsshowninFigure22,theaveragedividendyieldforEuropeanutilitiesissignificantlyhigherthanthebankinterestrates.

Figure 22: Average dividend yield for large European utilities, 12 trailing months

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3.4 Renewables

WhilegrowthofrenewableenergyremainsstronginEurope,manycountriesintheregionarenowwithdrawingtheirfinancialincentivesfor renewable generation. The next wave of opportunities will come in emerging economies, such as Nigeria and India, where the governmentshaveambitiousplanstodeveloprenewableprojects.

Valuation driversA number of factors are currently impacting the development of newrenewableprojectsintheEMEIAregion,including:

Mixed support in Europe: Concerns over high energy costs in Europe are undermining support for binding renewable targets in the EU. While countries such as Germany and the UK are slowly reducing their renewable feed-in tariffs (FITs), others such as Spain and the Czech Republic are bringing their tariffs to abrupt ends. Key updates include:

• Spain: According to the most recent renewable regulatory details, it appears recent subsidy changes will hit wind technologyhardest,absorbingabout65%ofthetotalcutsto remuneration. The revised regulations mean that all wind assetscommissionedbefore2005(about40%ofthe23GWtotal wind capacity) will now sell only at the wholesale market price, without any incentive on top of the pool price.

• Germany: Germany’s “Energiewende” or “energy transformation”requireselectricutilitiestogenerate35%oftheirelectricityfromrenewablesourcesby2020,50%by2030,65%by2040and80%by2050.WhileGermanyhasoneof the world’s largest solar capacities, the country has been reducing its FIT incentives over the past few years. Now a new draft proposal will see FITs paid to renewable power generators cuttoanaverageacrossalltechnologiesofUS$0.12/kWhby2015,downfromthecurrentUS$0.17/kWh.

• France: The European Commission has cleared the way for Frances’s new FIT, following the overturning of its previous regime.

• Greece: New legislation in Greece has lifted a ban on new large-scalesolarprojects,inplacesinceAugust2012,allowingprojectstotaling250MWtoreceiveFITsannuallyuntil2020.

Large supply/demand gap in some countries: Some countries, such as India, face a large energy demand-supply gap due to rapid industrial growth, population growth and urbanization. India’s new government is focused on achieving “Power for All” and overall energy security. Other drivers of growth within the Indian market include the abundance of untapped renewable energy resources andissuesrelatedtoavailabilityofcoalforthermalprojects.Indiaalsobenefitsfromstrongpolicyimpetus,includingthelaunchof the National Solar Mission, part of the National Action Plan onClimateChange(NAPCC),thataimstoachieve20GWsolarinstalledcapacityby2022.Meanwhile,StateElectricityBoardshave been mandated to source a proportion of their total energy from renewable sources, and the government continues to provide Generation-BasedIncentives(GBI)forwind-basedprojects.

Figure 23: Breakdown of renewable M&A deals in EMEIA,last 12 months

Source: Merger Markets, EY Analysis

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Figure 23: Breakdown of renewable M&A deals in EMEIA, last 12 months

Source: Merger Markets, EY analysis


Europe has clearly dominated the region’s inbound M&A activity, due mostly to divestments within the T&D sub-sector by large diversifiedutilitiesunderpressurefromweakdomesticeconomies.Going forward, India will emerge as the next destination for power sector investments, given the availability of cheap assets and the new government’s focus on market reforms and incentives,

especially for the renewable sector. MENA will also continue to remain appealing to investors, attracted by high growth and potential privatization and unbundling opportunities.

Our expectations regarding the capital outlook for EMEIA appear in Map 3.

3.5 The capital outlook: EMEIA

Map 3: Key trends of the EMEIA capital outlook

Interest in Africa’s energy assets was highlighted during Nigeria’s recent US$2.5bprivatizationprocessthatsaw local players emerge as winners of mostprojects.Asthecountrymovestoprivatize10gas-firedpowerplants,expect to see more involvement from foreign investors on the lookout for M&A opportunities. Nigeria is also planning to amend investment rules to channelmoreofthecountry’sUS$26bofpension funds into corporate bonds, to ensure long-term funding of power and infrastructureprojects.Weexpectthatstrong renewable growth will also drive M&A as Nigeria works toward achieving targetsof14%renewablecapacityby2020and20%by2030.

Saudi Arabia is considering the potential breakup of state-owned utility Saudi Electricity Co. The country’s industry regulator, the Electricity & Cogeneration RegulatoryAuthority,planstoofferasmuchas25%ineach unbundled company to international investors. SaudiArabiarequiresaUS$100binvestmentoverthe next decade to achieve its goal of boosting power generationcapacityintheKingdomby50%.

India is likely to receive more interest in2014-15,asforeigninvestors line up to acquire a number of distressed renewable assets.


Section 4

JapanWhile Japanese utilities are trading at historically normal levels, the upcoming market deregulation, which will break up Japan’s vertically integrated utilities and introduce full retail competition, is set to unlock significant value for currently undervalued businesses. Solar generation, backed by best-in-class incentives, has seen prolific growth over the last few years, but we expect to see other technologies, including off-shore wind, receive major interest going forward.

TheJapanesepowersectorisdominatedby10privatelyowned,verticallyintegratedutilities,eachoperatinginadefinedgeographicregioninJapan.SpurredonbythesignificantmarketreformsoutlinedbytheJapaneseGovernment,someofthesecompanieshavecommencedplanstoofferelectricityoutsidetheirtraditionalregions.Forexample,inMay2014,TokyoElectricPowerCompany(TEPCO)announced plans to sell electricity nationally, mainly in the service areas of its peers Kansai Electric Power and Chubu Electric Power.


Valuation dataBetween2007andMarch2011,diversifiedutilitiesinJapantradedatanaverageEV/EBITDAmultipleof8.8xonFY2EBITDA.However,followingthe2011tsunami,valuationsforthesecompanies spiked as analysts cut estimates for those companies withsignificantnuclearexposure.Sincethen,thegrouphastradedatanaveragemultipleof10.4x,whichisabout17%higherthanhistoricaverages.AsshowninFigure24,thegroupis currently trading at pre-tsunami levels, declining from highs of about15.0xtonear9.0xlevels.

Valuation driversAmid regulatory reform and ongoing debate regarding nuclear, valuationsofJapan’sintegratedanddiversifiedutilitiesareimpacted by various, complex factors:

Regulatory risk and significant costs of nuclear restarts: The closure of Japan’s nuclear power stations, following the Fukushima incidentin2011,hadahugeimpactonthecountry’selectricpowercompanies.In2012,theJapaneseGovernmentwasforcedto take a controlling stake in TEPCO to save the company from insolvency, while other utilities have also sought various forms of government backing. For example, Kyushu Electric Power Company islobbyingforanalmostUS$1bbailoutinequityfinancingfromtheGovernment-affiliatedDevelopmentBankofJapan,whileHokkaidoElectric Power is seeking similar support.

For these and other electric power companies, restarting the idled nuclearreactorsiscriticalbuttheyfacetheneedtofirstfundsignificantinvestmenttoupdatesafetymeasures.Atpresent,16ofJapan’s48nuclearreactorsaresubjecttotheNuclearRegulationAuthority’s screening process regarding safety measures. But even as utilities undergo this process, they have no guarantee of approval to restart their nuclear reactors. Despite this uncertainty, the Japanese Government seems committed to nuclear power remaininganimportantpartoftheenergymix.InApril2014,theJapanese Cabinet approved the new Basic Energy Plan, which states that nuclear power will be positioned as an “important base-load power source” and that the nuclear fuel cycle will continue to be promoted.

Figure 24: Average EV/EBITDA trading multiples for diversified utilities on FY2 estimates, 2007-14


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Figure 24: Average EV/EBITDA trading multiples for diversified utilities on FY2 estimates, 2007-14



Expected deregulation and entrance of new players: The incident at Fukushima highlighted a number of weaknesses in Japan’s power distribution system and sent power prices skyrocketing to among the world’s highest. These challenges were the catalyst tosignificantlytransformthecountry’spowermarket,withplansnowunderwaytounbundlethe10integratedutilitiesintoseparatepower generation, transmission, distribution and supply companies overthenextfewyears.InJune2014,Japaneselawmakersvotedto open up the residential electricity market to full competition. The change allows new companies to sell electricity and other services to almost 77m households and 7.4m small businesses fromaround2016.

Stagnant electricity demand slows valuation expansion: Overall, even with the third largest economy in the world, Japan has witnessedflat-to-negativegrowthinGDPinthepastdecade.Whilethe strong manufacturing sector supports the overall energy consumption levels, growing government and social support for energyefficiencyimplieslimitedupsideforthenation’selectricityconsumption.AsshowninFigure25,thetotalgenerationbyJapan’s10largestutilitiesin2013isevenlowerthanthe 2000levels.

Increasing reliance on imported fuels drives up costs: As nuclear reactors remain shut, Japanese utilities have been stepping up plans to increase the electricity output from coal and natural gas.

According to the Federation of Electric Power Companies in Japan, thecountry’s10integratedpowerutilitiesconsumedabout59.9mtonsofcoalinthefiscalyearended31March2014,up19.3%from the previous year and adding to the cost burden on utilities. This has been exacerbated by a weak yen which has driven up the cost of fuel import costs. Despite this trend, we anticipate only minimal increases in coal imports going forward, considering most capacityisatpeakutilizationandnonewcoal-firedpowerplantsare scheduled to come online this year.

Japanisthelargestimporterofliquefiednaturalgas(LNG)intheworld,consumingabout37%ofglobalLNGin2012inthewake of the Fukushima disaster. In a bid to alleviate fuel supply issues and reduce import costs, Japanese utilities are establishing interests in natural-gas-rich countries, especially in Australia and the US. Japanese companies have taken small equity stakes in Australia’sliquefactionprojectsandsignedcontractswithvariouslargeAustralianLNGprojects.JapanisalsoindiscussionswithUSexporters to secure additional natural gas supply, although these negotiationsaresubjecttoapprovedUSexportlicences.InMay2013,theUSDepartmentofEnergy(DOE)gaveapprovalforitsFreeport LNG terminal in the Gulf of Mexico to ship LNG to countries that do not hold free trade agreements with the US. Japan’s Chubu Electric and Osaka Gas took advantage of the decision, signingpreliminaryagreementstoimportover100Bcf/yeachfor20yearsfromthisterminalstartingin2017,whichcoulddriveapotential reduction in the high LNG prices.

Even when nuclear does restart in Japan, the country’s lack of indigenous uranium supply will result in it its continued dependence on imports from countries such as Australia, Canada and Kazakhstan.

Figure 25: Electricity generated by 10 largest diversified utilities in Japan, GWh, 2000–2013

Source: The Federation of Electric Power Companies in Japan

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Figure 25: Electricity generated by 10 largest diversified utilities in Japan, GWh, 2000-13

Source: The Federation of Electric Power Companies in Japan


Valuation dataSince2007,J-PowertradedatanaverageEV/EBITDAmultipleof10.9xonFY2EBITDA,intherangeof9.4xto12.8x.Thecompanycurrentlytradesat10.9x,inlinewithhistoricaverages.

Valuation driversJ-Power’s valuation is likely to rise as Japan continues to increase its use of thermal power amid the ongoing nuclear shutdown. Potential expansion of overseas IPP businesses by Japanese companies will drive higher earnings, while we may also see the growth of IPP’s domestic power business through the construction of new thermal plants.

Japan currently has only a limited number of pure-play IPPs, with Electric Power Development Company (or J-Power) the sole listed large-capIPP.J-Powersellselectricitytoregionalpowercompanies,usinglargelyhydroelectricandcoal-firedplants.Whilethecompanyiscurrentlybuildingitsfirstnuclearpowerplant,thestart-updateisunclear.J-Powerisaggressivelytargetingoverseasmarkets,withIPPprojectscurrentlyunderwayinThailandandIndonesia.




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Valuation driversWith uncertainty surrounding nuclear and current record usage of fossil fuels, it seems assured that renewable energy will remain a key focus for Japan. While current renewable output is dominated by hydropower, most new development is focused on solar, with wind running a distant second. Recent policy drafts released in Japanenvisionreaching25%to35%renewable generationby2030.Specificdriversinclude:

Strong incentives push solar growth: The FIT, which has been ineffectsince2012,setsfixedpricesthatutilitiesmustpayforrenewablegeneration.Theinitialtariffforsolar(about¥42/kWh(US$0.39/kWh)overa10-yearperiodforsmallsystemsandover20yearsforthoselargerthan10kW)wasabouttwicethatforwindprojects(¥23.10/kWh(US$0.21/kWh)).WhilethispricewasreducedinApril2013to¥36/kWhto¥38/kWh(US$0.33-0.35/kWh)andinApril2014to¥32/kWhto¥37/kWh(US$0.29-0.34/kWh), industry experts believe that the lower price is still very attractive to IPPs. This subsidy, which is substantially higher than prices in other renewable-friendly countries like Germany and Sweden, is driving strong solar growth in Japan.

Offshore wind provides a promising option: Wind generation has seen limited growth in Japan, with current installed capacity of only 2.3GW(orlessthan1%oftotalcapacity).Windprojectsrequirelengthy and complex environmental assessments and incorporation of expensive seismic safeguards for certain large plants. Despite the technologicalchallenges,expertsbelievefloatingwindpower(oroffshore wind) may have substantial potential for Japan. In March 2014,theindustryregulator(MinistryofEconomy,TradeandIndustry (METI)), decided to increase the FIT that utilities pay for electricityfromoffshorewindfarms,from¥22/kWhto¥36/kWh(US$0.20-0.33/kWh),whilecuttingpricesforsolarprojects.

4.3 Renewables

Figure 27: Cumulative renewable power generation capacity certified by the FIT regime in Japan, GW, 2012-13

Source: Japan Renewable Energy Foundation, EY Analysis

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(over 1000 kW)Small and medium-sized Hydro(under 1000 kW) BiomassGeothermal

Figure 27: Cumulative renewable power generation capacity certified by the FIT regime in Japan, GW, 2012-13

Source: Japan Renewable Energy Foundation, EY analysis


AsshowninFigure28,JapanhasseenonlyverylimitedinboundM&Aoverthelast12to16months.Whiletherenewablesectorreceived some interest in terms of M&A, the other P&U sub-sectors remained largely inactive. However, the ongoing reform of Japan’s energysector,includingtheunbundlingofits10largestdiversifiedutilities and the introduction of retail competition, will create significanttransactionopportunities.

Our expectations regarding the capital outlook for Japan appear in Map 4.

4.4 The capital outlook: Japan

As market reforms take shape, expect new players to enter the P&U space, especially in retail. We are already seeing new entrants position themselves for retail competition in Japan, with an aim to become registered power producers and suppliers (PPS). AsatJune92014therewere244registeredPPS,comparedwithabout100inSeptemberlastyear.

Despite declining FIT for solar, Japan is fast becoming a renewable energy hub withalargenumberofsolarprojectsandoffshorewindprojectsinthepipeline.Foreign investors are increasing their focus in the region. Goldman Sachs, for example, hascommittedabout¥50b(US$487m)toJapaneserenewablesprojects.

Map 4: Key trends of the Japan capital outlook

Figure 28: Number of M&A deals by subsector in Japan, last 18 months


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Figure 28: Number of M&A deals by subsector in Japan, last 18 months



1. Power and utilities sub-sector classifications

2. Methodology

• Tradingmultiples:Weusetwo-yearforward(FY2)consensusearnings/EBITDAestimatetocalculatethehistorictradingmultipliesfor P&U companies. Using these company level estimates, we estimate the sub-sector level averages. For example, regulated utilities tradedatanaverageP/Emultipleof12.3xonFY2EPSestimates.Toshortlistthecompaniesforinclusionintradingmultiplesanalysis,weusemultiplecriteria,including:(1)listedonamajorstockexchangeand(2)withamarketsizeofapproximately US$1bandabove.

• Transaction multiples: We analyze the available EV/EBITDA multiples for the M&A deals announced over recent years, to estimate the premium/(discount) paid by investors versus the historic trading multiplies for the respective P&U sub-sectors.

3. EY’s area classification

Sub-sector DescriptionTransmission and distribution (T&D) companies

These companies largely own network assets, including electric T&D wires and natural gas distribution assets. They feature commission-regulated rate structures that may or may not include decoupling provisions.

Generation companies and independent power producers

Generation companies and IPPs are companies whose primary business is the generation and sale of wholesale power. These companies may feature other businesses, such as retail and trading.

Diversifiedandintegratedutilities

These companies feature a diverse portfolio of power services, including regulated and unregulated components. Unregulated businesses might include merchant power, international businesses and non-utility ventures such as mining or construction as part of their portfolio.

Renewable companies The renewable sub-sector includes two types of companies: (1) generation companies deriving their powerunitsfromsolar,wind,hydro,biomassorgeothermaltechnologies,and(2)providersofmaterialandsupportingservicesthatincludefinance,constructionandmaintenanceofrenewableprojects.

Area Countries/regions Americas Canada, Mexico, South America, USA

Asia-Pacific Australia, Brunei, Cambodia, Greater China, Guam, Indonesia, Laos, Malaysia, Maldives, North Mariana Islands, Oceania, Philippines, Singapore, South Korea, Sri Lanka, Thailand, Vietnam

EMEIA Africa, Austria, Bangladesh, Belgium, CIS, CSE, FRaMaLux, Germany, India, Italy, Liechtenstein, MENA, Netherlands, Nordics, Portugal, Spain, Switzerland, UK and Ireland

Japan Japan

Notes and methodology

Notes and methodology




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About EY’s Global Power & Utilities Center In a world of uncertainty, changing regu-latory frameworks and environmental challenges, utility companies need to maintain a secure and reliable supply, while anticipating change and reacting to it quickly. EY’s Global Power & Utilities Center brings together a worldwide team of professionals to help you succeed — a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant sector issues. Ulti-mately it enables us to help you meet your goals and compete more effectively.

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specificadvice.

EY Global Transaction Advisory Services (TAS) Power & Utilities contactsTheEYglobalpowerandutilitiescommunitycomprisesaround700seniorclient-facingadvisersatEYmemberfirmsaround the world. Please contact your local EY Power & Utilities leader for assistance.

Doing the right deal in power and utilitiesDoing the right deal right can make a power and utility business morecompetitiveandprofitable.ClientsturntoEYmemberfirms’TransactionAdvisoryServicesprofessionalsforadviceandsupport through the life cycle of a transaction, from early stage to execution and post-deal activities. Whether the transaction involvesacquisitions,alliances,jointventures,sales,divestituresor securitizations, we help clients do the right deal at the right price. We help to determine the true value of an asset, set up the business and tax structure, optimize their position in the regulated revenue and pricing environments and execute the deal. We com-bine proven practices and consistent methodologies with fresh thinking, giving the advice our clients need to make informed deci-sions, potentially reduce risks and achieve successful outcomes.

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Global Contacts

Matt Rennie Global TAS Power & Utilities Leader Brisbane, Australia +61730113239 [email protected] @MattRennie_EY

Jaideep Malik Global Power & Utilities Analyst Gurgaon, India +124677-9235 [email protected]

Cara Graham Director, Global TAS Power & Utilities Brisbane, Australia +61730113145 [email protected]

Mexico Contacts

Alfredo ÁlvarezMexico Energy Leader+52 55 52 83 13 [email protected]

Rafael AguirreMexico [email protected]

Rodrigo FernándezMexico Tax+52 55 [email protected]

Rodrigo González LunaMexico Tax+5255 5283 [email protected]

Americas

Deborah Byers US South West TAS Power & Utilities Leader Texas, US +17137508138 [email protected]

Joseph Fontana Americas TAS Power & Utilities Leader New York, US +12127733382 [email protected]

Miles Huq TAS Power & Utilities Leader Maryland, US +14107833735 [email protected]

Gerard McInnis TAS Power & Utilities Leader Alberta, Canada +14032065058 [email protected]

Veeral Patel US Mid West TAS Power & Utilities Leader Chicago, US +13128792028 [email protected]

Robert Stall TAS Power & Utilities Leader Georgia, US +14048175474 [email protected]

Lucio Teixeira South America TAS Power & Utilities Leader Sao Paulo, Brazil +551125733008 [email protected]

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Capital outlook: power and utilities - EY