Europe Credit Research

01 July 2010

Spanish Utilities
Uncertainty reigns. Downgrade Iberdrola to NEUTRAL

• Last week the Spanish Socialist government announced that it had Credit Research
reached an agreement with the opposition Popular Party to hold a Olek Keenan, CFA
AC

cross-party review of all aspects of energy policy. As a result, the (44-20) 7777-0017
planned July electricity tariff increase has been cancelled because [email protected]
energy is crucial to competitiveness and the “welfare of citizens”. The Ryan Staszewski
parties have now held an initial meeting on the structure of the pact, (44-20) 7777-1981
and hope to reach agreement within a month on an energy strategy for [email protected]

the next 10-25 years which would not then be changed with each J.P. Morgan Securities Ltd.
successive change in government.

• The initial focus of the review is the cost elements of the system, but
the remit stretches across the energy mix, supply-side management,
nuclear policy, renewable targets and the development of
infrastructure. As such, we believe that all parts of the electricity value
chain are vulnerable to changes. By contrast, and despite the pact
looking at energy, there has been little focus on the gas markets or
networks. This should be reassuring for bondholders in Enagas.

• In this note we look at some of the potential changes, of which the most
potentially negative is changes to the tariff deficit. The Minister has
stated that the payment and securitization of the tariff deficit is not
under review, but we think it is the most dramatic way that politicians
could benefit consumers at the expense of utilities, so we review it in
detail. We also look at the possibilities of a tax on specific types of
generation or changes in the premium prices paid to renewable
generators, both of which are plausible, in our view. Finally, we
compare the relative exposure of various utilities to potential changes.

• Although we and others had long feared that utilities were vulnerable to
political intervention in the form of higher taxes or tougher regulation
(see A fundamental credit market view of sovereign risk, 9 Feb) this
review is far more politically high-profile and wide-ranging than we
had expected. As such, we expect spreads to remain weak until there is
more clarity and we think there is a reasonable chance of negative
changes large enough to prompt rating reviews.

• In terms of trading levels, unlike in our last discussion in What is

relative value relative to?, 25 May, Iberdrola bond yields are now
lower than Spanish government bonds. We do not believe this is
fundamentally justifiable, and think it is worth remembering that
previous utility issuance was discussed in terms of domestic
government bond yield plus a spread. As a result we downgrade to
NEUTRAL (5Y CDS 215-225, midday 1 July). We remain
UNDERWEIGHT Gas Natural (5Y CDS 255-265, midday 1 July).

See page 6 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

The agenda for the energy pact

The official points for discussion among the various parties are:

1) Generation mix to 2020 including coal, CCGTs and renewables;

2) Full liberalisation and a stronger role for regulator;

3) Costs of the electricity sector;

4) Infrastructure development;

5) Strengthening of energy efficiency measures;

6) Nuclear safety.

The tariff deficit issue

When Spain's electricity generation and supply market was liberalised by Electricity
Industry Law 54/1997, the ability to set the access tariff revenue remained with the
government, leaving open the possibility that the revenues of the system would be
insufficient to meet all the costs incurred. Rising fuel prices and a tighter market for
generation has driven repeated tariff deficits since 2000, and the Royal Decree Law
2/2005 made explicit that deficits had to be financed by the utilities in a percentage
share that was set in that law. The amounts that all of the utilities had recorded as
tariff deficit receivables in their balance sheets at YE09 are shown below, with
Endesa having both the largest share of the mainland deficit and a separate claim for
cost overruns in the supply of electricity in the islands 2001-8.

Table 1: Tariff deficit receivables v. EBITDA

€ million
Mainland Islands EBITDA
Endesa 4 656 2 242 7 228
Iberdrola 3 618 - 6 815
Gas Natural 1 267 - 3 937
EDP 536 - 3 363
Source: Company reports.

The government has repeatedly recognized the deficits that have arisen, although
there has been debate about the exact amount that the utilities claim, and the
companies have retained the right to recover the deficits, meaning they can recognize
the receivables in their balance sheets. The specific annual deficits have been
matched for collection from electricity customers via surcharges within the tariff, and
the utilities have sold some of these receivables to financial institutions, notably the
whole of the 2007 deficit.

In mid 2009, a new law was introduced to provide a permanent solution for the
problem by transitioning towards a tariff that fully meets costs by 2013, with any
shortfall in one period immediately recovered in the next. In the interim a tariff
deficit of up to €3.5bn in 2009, €3bn in 2010, €2bn in 2011 and €1bn in 2012 will be
permitted to accumulate, and the historic and future deficit will all be collected via
charges made in the regulated part of the tariff (including network charges etc).

2
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

In addition, the utilities will also be allowed to transfer (sell) any tariff deficit that
they owned to a new securitization fund to be set up by the government, which would
fund itself with the issuance of bonds which will benefit from a government
guarantee. The applicable laws have been put in place, and the fund now awaits only
the awarding of ratings and the filing of the CNMV prospectus. The current timetable
suggests this will be in July, and hence bond sales are likely to follow in September.
Once utilities notify the fund manager that they wish to sell the deficit, there are 12
months for the issuance of bonds to pay the utilities, after which he can only defer in
the event of exceptional market conditions. Clearly, however, the ability of Spanish
sovereign and sovereign-related entities to issue bonds at attractive spreads is
uncertain. As a result, we have always included these regulatory receivables as risky
assets with associated debt, until such time as they are actually transferred.

We believe that reductions in the amount of the tariff deficit that can be collected
would be very negative for the utilities, and are likely to be tempting for the
government because they are essentially costless to customers and voters. However,
it would break a very well established understanding that the utilities are funding the
deficit not bearing it. Yesterday’s press reported that Minister for Industry Sebastian
has stated that there will be no revision to any of the decrees relating to the tariff
deficit, and that the securitization should proceed. If this position holds through the
negotiations, that would be much better news for all of the utilities and especially
Iberdrola and Endesa.

Taxes on hydro and nuclear assets

There has also been press speculation that there could be additional taxes imposed on
hydro and nuclear generation (El Confidencial website, 12 May). This type of asset is
likely more "susceptible" relative to other forms of generation given low operating
costs once the large initial capital investment has been made, and most of this
investment in Spanish plants was made many years ago. In addition, these assets
benefited from "windfall" profits as carbon was added as a cost of production for
marginal cost generators.

The PP stated that the parties are investigating imposing a tax on nuclear life
extensions in a “model of inspiration […] closer to what the German government are
doing”. The ruling Socialist party has historically been against nuclear life
extensions, and seemed to reiterate that view this week, so it’s not clear what would
be included in the pact. However, this kind of deal is much less negative for the
utilities in terms of the NPV impact as the longer life offsets at least part of the tax.
However, a tax could also be imposed on an upfront basis, which could be a potential
challenge to liquidity.

Renewable subsidies
Renewable generation capacity requires subsidy to be profitable, and all European
countries have mechanisms to provide higher prices for electricity generated from
renewable sources. The Spanish system has historically been very attractive for
renewable investors, as Spain has built up one of the largest renewable generation
parks in Europe, partly because Spain has very few domestic energy resources
making renewables politically important. However, this has also increased the cost of
electricity in Spain materially, and there have been repeated press reports over recent

3
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

months that renewable subsidies could be reduced, at least with regard to the huge
amount of very high cost solar capacity registered in the last year.

Across countries, the usual framework for subsidy is that a plant agrees the lifetime
subsidy arrangement at the beginning of its construction, and so while subsidies may
be reduced for future plants, especially where the technology has become more cost-
competitive over time (as is the case for onshore wind), existing plants operate under
the original agreement. Both political parties are heavily committed to renewable
growth and to the existing renewable fleet, but we think that changes cannot be ruled
out in Spain because:

1. Spain has one of the highest proportions of wind in its generation mix in Europe
(representing c.18%) and there is a limit to how far it can grow given it’s an
intermittent source of power and cannot be relied in isolation to support a
country's electricity needs.

2. Solar technology is expensive and its commerciality in large scale grid use
remains largely unproven, so the size of subsidies required to promote
investment in this technology are significant.

3. Currently, Spain has overcapacity with respect to CCGT plants, which could be
utilized more if renewable investment were reduced for a time. This will produce
more CO2, but Spain is a relatively low carbon emitter in the European context
in any case.

Figure 1: Utility and sovereign bond curves (changes)

%
6 IBESM (25th May) GASSM (25th May) SPAIN (25th May)
IBESM (30th Jun) GASSM (30th Jun) SPAIN (30th Jun)
5.5

4.5

3.5

2.5

1.5
Jul-09 Apr-12 Dec-14 Sep-17 Jun-20 Mar-23 Dec-25

Source: J.P. Morgan.

4
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

Relative exposures
Figure 2: Gas Natural - Spanish generation output (FY09) Figure 3: Endesa - Spanish generation output (FY09)
Special regime (inc.
Special regime (inc.
renewables) CCGT
renewables)
6% 11%
Hydro 5%
9% Hydro
15%

Nuclear Imported coal

11% 20%

Other thermal
5%

CCGT Domestic coal

69% 9%
Nuclear
40%

Source: Company reports.

Includes Portugal
Source: Company reports.

Figure 4: Iberdrola – Spanish generation output Figure 5: Spain – National generation output
Other
Renewables Hydro Renewables
2%
16% 15% 9%
Oil Gas
8% 29%
Cogeneration
4%

Coal
22%
Nuclear
CCGT
34%
28%
Nuclear
Hydro 20%
Coal 10%
3%
Source: Company reports. Source: J.P. Morgan estimates, Company data.

5
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

Analyst Certification:
The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily
responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with
respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report
accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research
analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst(s) in this report.
Important Disclosures

• Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Gas Natural,
Iberdrola.
• Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for
Iberdrola within the past 12 months.
• Other Significant Financial Interests: JPMSI and/or its affiliates own a position of 1 million USD or more in the debt securities of
Gas Natural, Iberdrola.
• Client of the Firm: Gas Natural is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the
company investment banking services, non-investment banking securities-related services and non-securities-related services.
Iberdrola is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment
banking services, non-investment banking securities-related services and non-securities-related services.
• Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking
services from Gas Natural, Iberdrola.
• Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment
banking services in the next three months from Gas Natural, Iberdrola.
• Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other
than investment banking from Gas Natural, Iberdrola. An affiliate of JPMSI has received compensation in the past 12 months for
products or services other than investment banking from Gas Natural, Iberdrola.

Gas Natural - J.P. Morgan Recommendation History

Date Rating Instrument
03 Feb 05 Underweight CDS
Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation
changes were made in that period, the most recent change).

Iberdrola - J.P. Morgan Recommendation History

Date Rating Instrument
07 Aug 08 Overweight 5Y CDS
Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation
changes were made in that period, the most recent change).

Explanation of Credit Research Ratings:

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recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the
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three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s
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Valuation & Methodology: In J.P. Morgan’s credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral)
based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit
rating agencies and the market prices for the issuer’s securities. Our credit view of an issuer is based upon our opinion as to whether the
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issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital
investment). We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable
companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer’s balance sheet relative to
the operational leverage in its business.

6
Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

J.P. Morgan Credit Research Ratings Distribution, as of June 30, 2010

Overweight Neutral Underweight
EMEA Credit Research Universe 26% 50% 25%
IB clients* 55% 64% 55%
Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage.
*Percentage of investment banking clients in each rating category.

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Olek Keenan, CFA Europe Credit Research
(44-20) 7777-0017 01 July 2010
[email protected]

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