#### Need to know

• German power companies RWE and E.on split their renewable operations from their fossil fuel legacy – and others have followed suit.
• The results have been unexpected – the legacy fossil-fuel divisions have proved to be more robust than many thought.
• Risk management challenges for the new companies include development and construction risk, unpredictable renewable supply and regulatory uncertainty.
• Innogy, spun off to handle RWE’s renewables, hit unexpected costs and had to be rescued by its former parent and E.on.
• For the new spinoffs, with unpredictable exposure and smaller balance sheets, good risk management is vital.

The pressure on energy companies to invest in renewable generation and reduce carbon emissions has been building for years but, in 2016, it began to change the structure of some of the sector’s largest companies. Germany’s E.on and RWE were the first to separate their fossil fuels and renewables businesses, creating new standalone businesses, and others have subsequently followed with similar moves.

As regulators insist strongly on the importance of clean energy targets, the role of the risk management function must also evolve. Traditional risks such as market risk and credit risk continue to be important, particularly for commodities prone to sudden price moves and credit quality issues, but reputational risk, strategic risk and political risk have also risen up the agenda, requiring new types of expertise in the risk department.

“Energy policy is a big political risk in our industry because there has been uncertainty in terms of how the energy mix should look in the future in different parts of the world. Chief risk officers need to understand what sort of portfolio we will have in 10 or 20 years’ time, which requires an understanding of the transformative trends in policy and technology,” says Novera Khan, chief risk officer of Uniper, the new company formed when E.on spun out its fossil fuels business in 2016.

### First movers

E.on’s original decision to transfer fossil fuels into a separate entity was taken as far back as 2014, when Germany’s push towards clean energy had led the company to report falling profits and impairment charges. Just a few months after Uniper launched its operations in January 2016, its rival RWE made a mirror-image move by transferring its renewable, network and retail businesses into a new entity known as Innogy.

The creation of Uniper and Innogy within just a few months of one another marked a fundamental change for Germany’s energy sector, with much clearer delineation between renewables and fossil fuels. While E.on and RWE chose to spin off different parts of their businesses, analysts believe such splits to be broadly positive for investors, because, while some level of reassessment and realignment is inevitable, it ultimately makes it easier for them to focus on particular types of energy.

“This is not a homogenous sector and we have often seen utilities underperforming even though one subsection may be doing really well – commodity prices will affect fossil fuels, for example, but falling interest rates will affect regulated businesses. Investors appreciate the opportunity to be more targeted in their choice of investment and to play particular themes, while both companies are now on a much safer and securer footing, with stronger balance sheets,” says Lueder Schumacher, an energy analyst at Societe Generale.

Risk managers see it in a similar way, suggesting the separation of energy companies reduces complexity in the sector. “Investors on both the debt and equity side need to be able to model the business to understand the key risks and earnings drivers. This is much harder for a complicated business with multiple components, so splitting businesses up and reducing complexity should drive greater interest from investors,” says Glen Mackey, chief risk officer at NRG Energy in Princeton, New Jersey.

###### This is not a homogenous sector and we have often seen utilities underperforming even though one subsection may be doing really well – commodity prices will affect fossil fuels, for example, but falling interest rates will affect regulated businesses

Lueder Schumacher, Societe Generale

“In 2016, utilities were rather out of favour, but regulated utilities were still doing well because earnings weren’t affected by falling commodity prices. E.on was the first to spin off its commodity assets, but actually Uniper did rather better than expected as commodity prices went through the roof and the black sheep of the business turned out to be whiter than white,” says Schumacher.

Meanwhile, Innogy had a much more difficult inception than expected and was forced to issue a profit warning last year as a result of challenges encountered in its UK retail business and rising costs associated with digitisation. In March 2018, E.on and RWE agreed to split Innogy’s assets between them. Through a combination of asset and share swaps, RWE transfers its stake in Innogy to E.on, but RWE gathers up all of the renewables business and E.on shifts its focus to regulated energy networks.

Given the national push towards renewable energy in Germany that led E.on to its radical restructuring, Uniper might well have been expected to struggle in its early months while Innogy, with its renewable energy business, would be more successful. In fact, the reverse happened. Buoyed by rising commodity prices, Uniper went on to outperform expectations, securing a listing on the Frankfurt Stock Exchange in September 2016 and a debut in the euro bond market just a few months later.

This latest continuation of the narrative, in which part of the original RWE now gets pieced back together with rival E.on, shows that, despite the continuing move towards decarbonisation, standalone renewables businesses may not always be more successful than those focused on fossil fuels, and investors’ standard expectations of a company’s performance can sometimes prove to be misplaced.

“The market expects commodity-linked utilities to show some volatility in earnings at times, because their earnings move in line with underlying commodity prices, but when Innogy had a profit warning and was subsequently downgraded, it came as much more of a shock to the market,” says Schumacher.

“The recent asset swap will allow RWE to focus on renewables while Innogy’s regulated earnings go to E.on, which adds further value and clarity for investors that want to align themselves with one sector or the other,” he adds.

Uniper, on the other hand, has prospered, with 12,000 employees and operating income in line with expectations at €1.1 billion ($1.2 billion) last year. Khan attributes Uniper’s success to its focus on a robust financial and risk management strategy that has stabilised the company’s balance sheet for long-term growth. While further challenges may lie ahead as rivals continue to restructure, Uniper appears to have managed the risks associated with the spin-off up until now. ###### Splitting a company always carries a level of risk because you need to make sure the shareholders of the two parts will be able to unlock greater value than they could for one consolidated entity Novera Khan, Uniper “Splitting a company always carries a level of risk because you need to make sure the shareholders of the two parts will be able to unlock greater value than they could for one consolidated entity. This has certainly been the case because we have been able to focus more on our part of the energy world and have already delivered enhanced returns for shareholders,” Khan says. ### Managing diverse risks This radical shakeup of the energy sector is not confined to Germany. Denmark’s Ørsted announced last year that it would move almost entirely to green energy, while oil giant Shell plans to cut carbon emissions by 50% by 2050. In the US, integrated power company NRG completed the sale of its renewables platform to Global Infrastructure Partners for$1.3 billion on August 31.

As energy companies continue to restructure and investors look to refocus on particular types of energy, risk managers must also realign themselves to the particular business for which they are responsible. Renewable energy projects pose different types of risk to fossil fuels, and risk departments must be sufficiently versatile to switch from one to the other while also managing the political and regulatory uncertainty that dominates the energy sector today.

“The risk factors associated with running a standard generation portfolio are very different to those for a renewables portfolio,” says NRG’s Mackey. “For traditional commodities and fossil fuels, market risk is prevalent because of price volatility, while credit risk is important when it comes to energy supply. Many of the coal companies are very poorly rated, for example, so there is a lot of credit risk associated with long-term contracts.”

When managing a renewables portfolio, risk managers must assess development and construction risks for their capital-intensive generation assets, while also looking at the future reliability of energy supply, which can be harder to forecast than for conventional energy types.

“Once renewable facilities are completed and go into production, margins are driven by whether the wind blows or the sun shines, which obviously can’t be controlled or even hedged. In reality, the risks are different to those for traditional fossil fuels, but equally difficult to predict and hedge with any certainty,” says Mackey.

Commitment to renewable energy varies across the US, and some states have been more active than others in setting targets and supporting the move towards decarbonisation. Some state legislators require utilities to solicit and sign long-term contracts with renewable generators, but high construction costs and environmental uncertainties are unavoidable.

“Utilities have had to use their balance sheets to support renewable development, which is positive, but these projects are long-term and it creates a significant exposure to renewable markets, especially if prices are likely to collapse in the future,” says a risk manager at one large US energy company.

###### Once renewable facilities are completed and go into production, margins are driven by whether the wind blows or the sun shines, which obviously can’t be controlled or even hedged

Glen Mackey, NRG Energy

“We try to assess how far out of the money the contracts are, and so derive mark-to-market exposure with particular projects and the impact they would have on the balance sheet … We try to minimise accounting and regulatory risk to ensure future recovery and reduce the impact on our financial statements.”

### Disciplined risk management

Nearly three years on from the break-up of RWE and E.on, the energy sector continues to evolve and more shakeups are undoubtedly yet to come, but the experience of some of the companies that have restructured underscores the importance of disciplined, versatile and multi-faceted risk management.

Uniper’s Khan acknowledges that reputational risk has become far more important than in the past, given the negative connotations associated with fossil fuels and the perception at the time of the company’s creation that it was the black sheep of the E.on family. The company responded by making a sustained effort to articulate its strategy to investors and stakeholders, leading to its Standard & Poor’s credit rating being upgraded to BBB in April 2018.

“Risk management has been at the heart of Uniper since inception because we were very conscious that as a new entity we had to gain credibility in the capital markets and needed to manage ourselves in a very disciplined manner to get our balance sheet and financials in good health. We inherited only one-third of E.on’s balance sheet but two-thirds of its risk, so this had to be managed very diligently to put us on a strong footing and secure a good credit rating,” Khan explains.

While the spinoff did not necessarily involve an explicit decision to offload more risk to Uniper, that the portfolio of products the new company inherited from E.on was subject to a more diverse set of risks – ranging from strategy and policy risk to market and credit risk – than might typically affect a regulated renewables portfolio.

Risk managers must make sure that the full range of risks facing energy companies is properly understood at the board level, given that the board will typically set risk appetite. At a time when some companies are being incentivised and even mandated to invest in renewable energy, it is also the job of the risk department to ensure there is sufficient balance sheet availability to support such investments.

“Risk factors are changing, so the skillsets in the team have to be very dynamic, and analysts need to be subject-matter experts in their particular field,” Mackey says. “Risk departments also need much more sophisticated data management than in the past, both for the purposes of reporting and developing dynamic modelling assessments. As our data warehouses grow, we need the right skillsets to put that data into a form in which it can be used to draw useful insights.”

Energy companies now face a wide range of risk management responsibilities, and the headroom for shocks to impact a business such as Uniper is much lower than it was when it was part of E.on – meaning robust enterprise risk management is critical, concludes Khan.

“Whether it’s a bad decision in the markets, a problem with a construction project or power plant, or something missed on the strategy side, these are all now much bigger risks that need to be prudently managed all the time,” she says.

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