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Global Utility White Paper CONFIDENTIAL

• European Utilities

We believe European utilities have the potential not only for the strongest outperformance but also for the greatest alpha generation. Since the financial crisis, European utility earnings have declined approximately -45% which is slightly less than European broader market earnings declines of -51% (Stoxx 600 or SXXP) and -58% (Stoxx 50 or SX5E). Prior to the crisis, European utilities used to trade at a 20% premium to the broader market. During the recovery, European utilities suffered a -43% derating and now trade at a 31% PE discount to the broader market. Most of this derating is explained by the European utilities’ lack of participation in the European broad market PE multiple re-rating (SX5E +115%, SXXP +76%) since the recovery beginning in 2009. Moreover, approximately 40% of the sector is now trading below book value.

Clearly, investors appear to believe that earnings have troughed for European companies broadly, but not for European utilities. Concerns about political intervention along with low power and carbon prices have prevented a re-rating of the sector. However, we are comfortable that we are close to a bottom, and that optionality is asymmetrically skewed to the upside for the European utilities, as many generation assets are producing power at close to cash cost.

Relative to US utilities, European utilities have underperformed by -40% and the relative PE has de-rated by -11% since the crisis. The average European utility’s relative dividend yield is now 95% higher than that of US peers before the crisis. Although some would argue that dividend cuts are coming (we agree broadly, and see several interesting short opportunities), we do not see the entire sector’s dividends being cut by 50%, as stock prices imply. As such, the sector today has dividend support even though some dividend cuts will undoubtedly happen.

In addition to dividends, potentially higher power prices from both higher European coal and carbon prices could also provide support. At present, the carbon market (EU ETS) in Europe is dysfunctional, with carbon trading at €5/tonne, well below the cost required to spur investment in low-carbon generating capacity. We expect the carbon market to be restructured (already being discussed), thus raising the price of carbon and increasing power prices. Moreover, with China’s GDP growth reaccelerating and 70% of the resulting rise in electricity production generated from coal, we would anticipate a modest growth in coal consumption in the Asian seaborne market, thereby supporting South African and European coal prices. Given our view of rising US natural gas prices, we expect coal exports from the US to Europe to fall. These are all factors that should support European coal prices even before accounting for greater demand for coal that might come from Europe should growth return. Notwithstanding, short opportunities will remain in several European markets due to the influence of renewables.

Moreover, if the European Central Bank were to lower its Main Refinancing Operations rate, currently 75 bps, and provide other monetary policy support, we would expect not only increased demand for electricity (which would increase coal consumption) but also a weaker Euro would increase the Euro price of coal (in Europe) and thus power prices. There are a number of factors at work here, and it is difficult to predict levels with any degree of accuracy, but even small changes would have a significant impact on the sector. For example, a combination of a +10% increase in coal prices, -10% decrease in the Euro/$ exchange rate, and a rise in the carbon credit price from €5 to €10/tonne would produce 25-50% earnings upside in many continental European utilities.

Below is a partial list of structural changes driving long/short opportunities in Europe:

9 Electron Capital Partners, LLC
For exclusive of Jeffrey Epstein

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