Credit Opinion: PGE Polska Grupa Energetyczna S.A.

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Credit Opinion: PGE Polska Grupa Energetyczna S.A.

Global Credit Research - 02 Jun 2015

Warsaw, Poland

Ratings

Category Moody's Rating

Outlook Stable

Issuer Rating Baa1

PGE Sweden AB (publ)

Outlook Stable

Bkd Senior Unsecured Baa1

Contacts Analyst Phone Joanna Fic/London 44.20.7772.5454 Raffaella Altamura/London Andrew Blease/London Key Indicators

[1]PGE Polska Grupa Energetyczna S.A.

12/31/2014 12/31/2013 12/31/2012

(CFO Pre-W/C + Interest) / Interest Expense 47.1x 84.3x 87.8x

(CFO Pre-WC) / Net Debt -2847.0% -316.4% -454.4%

RCF / Net Debt -2080.8% -254.2% -283.4%

[1] All ratios are calculated using Moody's standard accounting adjustments. Source: Moody's Financial MetricsTM

Note: For definitions of Moody's most common ratio terms please see the accompanying User's Guide.

Opinion Rating Drivers

- Leading Polish vertically integrated energy group with a long position in generation based mainly on lignite and coal

- Low power prices and increasing costs of CO2 allowances impacting profitability of the generation portfolio - Modest contribution of lower risk regulated distribution activities

- Large capex programme will result in a deterioration in the financial profile from the current strong position - Uncertainty regarding future set up of the energy market

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PGE Polska Grupa Energetyczna S.A. (PGE) is a holding company for a vertically-integrated energy group, which is the largest utility in Poland. The group's businesses are (1) power generation, mainly in lignite and coal power plants, which have a total installed generation capacity of 12.6 gigawatts (GW); (2) electricity distribution, which accounts for around 28% of the group's EBITDA; and (3) supply of electricity to around 5 million customers. The company has about 35% market share of the generation segment in Poland and its activities are supported by the ownership of Poland's lignite mines, which provide 71% of PGE's fuel needs.

PGE is currently approximately 58.4% owned by the Government of Poland (A2 stable). The remainder of shares are listed on the Warsaw stock exchange.

SUMMARY RATING RATIONALE

PGE's rating assessment reflects the company's strong position as a dominant generator of electricity in Poland, and as an integrated energy group. The company benefits from a low cost lignite-fueled generation fleet. However, these positives are offset by the exposure to power markets in the weak price environment and high exposure to carbon, albeit reduced due to the free carbon dioxide emission allowances. The assigned rating further takes into account an expected increase in leverage due to negative free cash flows arising from a significant capital expenditure programme.

PGE's rating incorporates one notch of uplift for potential support from its owner, the Government of Poland (A2, stable outlook).

DETAILED RATING CONSIDERATIONS

LEADING POLISH VERTICALLY INTEGRATED ENERGY GROUP WITH A LONG POSITION IN GENERATION BASED MAINLY ON LIGNITE AND COAL

PGE's is the largest energy group in Poland with installed capacity of some 12.6 GW as of end-2014, which accounts for some 33% of the installed capacity in the country. The share of electricity production is also very high. PGE's electricity generation amounted to 54.8 TWh in 2014, which accounts for about 35% of the market. PGE's generation capacity is based predominantly on lignite (sourced internally) and coal (sourced under long-term contracts). The group owns the two largest lignite mines in Poland, making it significantly independent from fuel suppliers. In 2014, around 71% of electricity generated by PGE group was fuelled by its own lignite resources with the remainder coming mainly from coal (22% of the total). Other generation is fairly limited, although is increasing with commissioning of new wind farm developments.

Although PGE's generation mix is in line with the average in the Polish market and large reserves of relatively cheap lignite and coal are readily available, such a high dependence on coal will require the purchase of additional CO2 permissions, exposing the company to a significant cost disadvantage. Whilst we consider that access to own fuel sources is beneficial and PGE's lignite plants are well positioned in Poland's merit order, the group lacks diversification of generation sources compared with large Western European utilities. The group also lacks geographic diversification, which leaves it exposed to developments in the domestic market.

As an integrated utility, PGE is able to capture value across the energy chain. However, the group lacks a balanced integrated position with sales to end users of 39.6 TWh compared with 54.8 TWh of electricity generated in 2014. The group sells the energy on the exchange as well as under bilateral contracts. We note that margins in the supply segment have come under significant pressure and have been further affected by the higher costs of certificates of origin. We expect pressure on margins to continue. More generally, we also consider that the lack of transparency regarding the company's hedged position is a constraining rating factor.

LOW POWER PRICES AND INCREASING COSTS OF CO2 ALLOWANCES IMPACT PROFITABILITY OF THE GENERATION PORTFOLIO

Earnings in the conventional power generation segment have come under significant pressure as power prices collapsed. The key drivers have been falling coal and low CO2 prices, coupled with sluggish demand and

expansion of renewable capacity. Polish power prices have recovered since their lows in 2013 and have started to trade at premium to the German market. Current base load forward contracts for 2016 are at around

PLN165/MWh, which is equivalent to EUR40/MWh and compares with approximately EUR31/MWh in Germany. One of the drivers for this premium was an introduction of the operational reserve mechanism (ORM) in Poland, which impacted especially peak prices. Whilst the impact of ORM will be lower this year, we consider that the premium may be sustainable over the short to medium term due to lack of interconnection capacity with Germany, but we also do not expect any major recovery in the wholesale power prices in the near to medium term, which

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but we also do not expect any major recovery in the wholesale power prices in the near to medium term, which together with CO2 costs will drive PGE's generation segment profitability.

PGE's generation portfolio has a high exposure to carbon with emissions of some 1 tonne per MWh, which is a high ratio compared with the large Western European utilities. The current prices of CO2 are at some

EUR7.4/tonne and we do not expect any significant increase over the medium term due to oversupply of emission rights on the market and decreased demand from the industry sector due to the economic slowdown. Whilst the exposure to carbon is high and will continue to affect PGE's profitability in the generation segment, the negative impact will be somewhat reduced due to the free CO2 emission allowances that the group is entitled to receive until 2020.

MODEST CONTRIBUTION OF LOWER RISK REGULATED DISTRIBUTION ACTIVITIES

PGE's share of lower risk regulated distribution activities has increased as the earnings in the conventional generation segment were pressured, but remains below that of its Polish peers. We expect these activities to account for some 30% of the group's EBITDA in the medium term.

Electricity distribution tariffs in Poland are set by the Energy Regulatory Office (ERO) using a price cap model. As a general rule, the distribution companies' revenues are determined in order to cover the so-called justified costs: operating costs, capital depreciation charges, tax charges, cost of purchase of electricity to cover balancing differences, in addition to providing a return based on a weighted average cost of capital (WACC) on the companies' RAB. The nominal WACC set by the regulator is adjusted on an annual basis to take account of predefined parameters and the average yield on Polish treasury bonds. The current pre-tax WACC is set at 7.2%. The Polish regulatory framework has improved over the past years, although its transparency is below the levels seen in more developed Western European jurisdictions. Whilst historically it appeared to be spared from political interference, the recent decision regarding a cut on return of 5%, which we understand is a one-off, is negatively weighing on our assessment. We currently do not expect any major impact of changes to the regulatory

framework starting from 2016, when the ERO is expected to put more focus on qualitative assessment with a penalty/ reward regime for under-/over-performance.

Overall, the presence of regulated cash flows is supportive of PGE's credit profile, although it is fairly modest in comparison with other Polish energy groups, such as for example, ENERGA S.A. (Baa1 stable). It also lacks transparency and predictability of the more developed Western European jurisdictions.

LARGE CAPEX PROGRAMME WILL RESULT IN A DETERIORATION IN THE FINANCIAL PROFILE FROM THE CURRENT STRONG POSITION

PGE's investment plans in the total amount of PLN50 billion in the period 2014-20 are sizeable in absolute terms and compared with the historical amounts. The majority of investments will be targeted mainly in conventional generation. In particular, PGE plans to spend some PLN16 billion on existing plants and PLN15 billion on development of new capacity including Opole power plants based on hard coal. The two units with 900 MW of installed capacity each are expected to be commissioned in 2018 and 2019. Total investments are PLN11.6 billion. Other projects include Turow power plant based on lignite and with an installed capacity of 496 MW (gross). We note the cautious approach to investment in nuclear plant, which would be Poland's first. This is positive considering the risks involved in development of new nuclear plants given the long construction lead times, possible budget overruns and substantial upfront capital costs. The current plans assume continuation of preparatory works on this project with some PLN400 million to be spent in 2015-17. Future spending will be dependent on the result of the tender for a consortium responsible for choice of technology, construction and its financing, expected to be completed by end of 2018.

PGE's low leverage and strong liquidity mitigate some of the risks associated with the implementation of its sizeable investment programme. Execution risk, however, remains and there is uncertainty around the new projects' profitability considering the new entrant capacity costs. We expect PGE's leverage to increase, although we also note that building up of debt will depend on the pace of the investment programme as well as other demands on cash flow, including M&A activity and dividend distribution. At present, we expect financial metrics to be well positioned against the guidance set for the current ratings, namely funds from operations (FFO)/net debt in the thirties in percentage terms and FFO interest cover above 5.0x. We note that these levels are commensurate with management's stated leverage target of a maximum net debt/EBITDA of 2.5x.

ONE NOTCH UPLIFT FOR GOVERNMENT SUPPORT

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held. Despite a gradual reduction in the state's share in PGE, we believe that the Polish government expects to retain its controlling stake in the company over the long term.

We view PGE as having a strategic role for the Polish government as a provider of essential services and a key player in the implementation of the state energy policies. PGE generates around 35% of total domestic electricity production and it is the largest vertically integrated electric utility. Its strategic importance to the overall Polish economy and also reflects the fact that it represents one of the largest employers and contributors to the state budget. Although no direct state guarantees are currently provided, we believe that the Polish government recognises the strategic importance of PGE, which is reflected by the nomination of the company as a main partner for building nuclear-based generation capacity in Poland.

In light of the above considerations, PGE's Baa1 rating factors in one notch of uplift to the company's standalone credit quality expressed by us as a baseline credit assessment (BCA) of baa2.

UNCERTAINTY REGARDING FUTURE SET UP OF THE ENERGY MARKETS

We understand that the Polish government is considering a number of different options for the energy sector, in which it holds majority stakes and/or controls the four largest energy groups including PGE, Tauron, ENEA and ENERGA. The contemplated scenarios include consolidation in the sector, which seems to be driven by

considerations regarding security of power supply in Poland and delivery of the broader investment objectives for the country. No details regarding possible consolidation scenarios have been revealed yet. Whist PGE

management stated that they could see a rationale in its merger with ENERGA, we note that such a transaction was rejected by the Antimonopoly Office in 2011.

In addition to potential mergers or acquisitions between the large state-owned utility groups, the government is also working on a rescue plan for the Polish mining sector, which faces both liquidity and structural problems. The government proposed solution for Kompania Weglowa S.A., the largest mining group in Poland, included spin-off of the profitable mines with the potential equity investment from the utility groups. The plan is still, however, a work in progress. Since PGE, as well as other Polish utility groups, are reliant on hard coal deliveries for their power generation, the future of the mining sector and any measures to be undertaken to improve its competitiveness and/ or preserve its status as one of the largest employers in the country, are important considerations for our

assessment of PGE.

Overall, the uncertainty regarding future evolution of the market and role of PGE in that process weighs negatively on our assessment of the group.

Liquidity Profile

As of end-March 2015, PGE had unrestricted cash of PLN4.4 billion and availability under bank facilities of PLN3.4 billion.

PGE does not face any material debt maturities in the near term. The current biggest single debt maturity is a domestic bond in the amount of PLN1 billion due in 2018. We note, however, that the group's sizeable capex programme will result in negative free cash flow and will result in increased funding needs over the medium term. We expect PGE to continue to use both domestic and international bond markets to finance its operations. Rating Outlook

The stable outlook assumes that PGE will manage its capital structure such as to ensure a financial profile aligned with our guidance for the Baa1 rating which includes funds from operations (FFO) interest coverage of at least 5.0x and FFO/net debt above 30%.

What Could Change the Rating - Up

Upward rating pressure is unlikely in the short to medium term given the challenges that PGE faces in terms of carrying out its capital investment programme and the anticipated decline in its credit metrics. Over the medium to long term, we would consider an upgrade in the event of improved clarity around the future shape of the energy market in Poland coupled with a successful implementation of the investment projects and a strong financial profile of the group.

What Could Change the Rating - Down

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guidance was not met; (2) the group's FFO interest coverage ratio were to fall below 5.0x, FFO/net debt were to decline below 30% on a sustainable basis; (3) there was a material adverse change in the regulatory framework in Poland; or (4) the group were to embark on the nuclear investment without adequate financial and contractual risk protections. In addition, a deterioration in the credit quality of the Government of Poland and/or reduction in the support assumptions currently incorporated into our assessment would likely put a negative pressure on PGE's ratings.

Other Considerations METHODOLOGY GRID:

PGE's rating reflects our assessment of the company's business profile and financial performance in line with our rating methodology for Unregulated Utilities and Unregulated Power Companies, published in October 2014. The current rating is below the grid indicated rating as PGE is yet to implement its capex programme, which we expect to result in an increase in leverage. Other considerations include uncertainty around the future shape of the Polish energy markets and PGE's role in that process.

Rating Factors

PGE Polska Grupa Energetyczna S.A.

Unregulated Utilities Current [1]Moody's 12-18 months forward viewAs of June 2015

Factor 1 : Scale (10%) Measure Score Measure Score

a) Scale Baa Baa

Factor 2 : Business Profile (40%) a) Market Diversification Ba Ba b) Hedging and Integration Impact on Cash

Flow Predictability

Ba Ba c) Market Framework and Positioning Baa Baa d) Capital Requirements and Operational

Performance

B B e) Business Mix Impact on Cash Flow

Predictability

A A

Factor 3 : Financial Policy (10%)

a) Financial Policy Baa Baa

Factor 4 : Leverage and Coverage (40%) [2][3] a) (CFO Pre-W/C + Interest) / Interest

Expense (3-yr avg.)

68.7x Aaa 28-35x Aaa

b) (CFO Pre-WC) / Net Debt (3-yr avg.) -512.8% Aaa 70-80% Aa c) RCF / Net Debt (3-yr avg.) -366.5% Aaa 50-60% Aaa

Rating: a) Indicated BCA from Grid a2 a3 b) Actual BCA Assigned baa2 baa2

Government-Related Issuer Factor a) Baseline Credit Assessment baa2 b) Government Local Currency Rating A2

c) Default Dependence Very

High

d) Support Strong

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[1] This represents Moody's forward view; not the view of the issuer; and unless noted in the text, does not incorporate significant acquisitions and divestitures [2] As of 12/31/2014 [3] All ratios are calculated using Moody's Standard Adjustments; Source: Moody's Financial Metrics

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