Maciej Bukowski, Urszula Siedlecka, Aleksander...

Maciej Bukowski, Urszula Siedlecka, Aleksander Śniegocki

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Coalapse – will fusion with the energy sector save Polish mining?

Authors:

Maciej Bukowski,

Urszula Siedlecka,

Aleksander Śniegocki

Warsaw Institute for Economic Studies

Aleje Jerozolimskie 99 lok. 18

02-001 Warszawa

www.wise-europa.eu

WiseEuropa would like to thank the Greenpeace Polska Foundation for assistance in preparing this report.

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© Copyright by Warszawski Instytut Studiów Ekonomicznych, Warsaw, 2016

ISBN: 978-83-64813-20-7

Free copy

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Executive Summary 5

Recommendations 7

1. Introduction 10

2.

Methodology

11

2.1. Scope of the analysis 11

2.2. Mining restructuring process 12

2.3. Impact of the consolidation on energy companies and

investors

15

2.4. Impact on consumers and taxpayers 16

3.

Outlook for Polska Grupa Górnicza

20

3.1. Restructuring scenarios 20

3.2. PGG’s impact on energy companies 25

3.3. PGG’s impact on consumers and taxpayers 28

4.

Sectoral integration

31

4.1. Restructuring scenarios 31

4.2. Impact of sectoral integration on energy companies 35

4.3. Impact of sectoral integration on consumers and taxpayers 38

5.

Consolidation during permanent stagnation on the coal

market 41

5.1. Forecasted stagnation of coal prices 41

5.2. Outlook for PGG under stagnation of coal prices 42

5.3. Sectoral integration under stagnation of coal prices 47

6.

Summary

50

Bibliography 52

List of figures 53


5

Executive Summary

• Integration of the mining industry and the energy sector will have negative impact on

the economy, unless it is accompanied by closing down of the permanently unprofitable mines and by a

significant improvement in mining productivity. This means limiting coal production

in the top three Polish mining companies by over 40% and reducing employment by half

by 2018. Making a swift decision to transfer the unprofitable mines to the Mine Restructuring Company

in order to phase them out will limit the social cost of restructuring, stretching it over

a period of 2 to 3 years. After this period, the EU regulations will make it impossible to support the

liquidation of unprofitable mines, which may lead to uncontrolled bankruptcies and sudden lay-offs of

all miners.

• Polska Grupa Górnicza (PGG), formed in accordance with the agreement concluded in April 2016

between the government and the investors together with trade unions, has little chance

of becoming profitable. PGG’s initial business plan assumed supporting its operations on

the condition that the prices of coal rise and that the productivity improvement scheme to be

consistently deployed in the coming years is successful. However, the implied return on capital was not

attractive enough for investors. The April agreement further deteriorated the outlook for the Group:

even if the prices of coal increase and the assumed improvement in productivity is achieved, the Group

will require further recapitalisation at the beginning of the next decade.

A persistent stagnation of prices and failure of the restructuring process would result in PGG facing

bankruptcy in 2020 at the latest, and perhaps as early as in 2018. Only a permanent closure of

unprofitable mines (around half of the mining capacity) and an appropriate reduction in employment

will give PGG investors a real chance to generate a profit when the prices of coal rebound and to reduce

losses if they are stagnant.

• Direct acquisition of mines by energy companies is unprofitable and may result in multi-billion zloty

losses. A less risky option for the energy sector is equity interest in mining companies, which makes it

more difficult to indefinitely transfer losses of unprofitable mines onto energy companies. However, just

as in the case of the PGG investment, only an approach that assumes a prompt discontinuation of

unprofitable mining operations and focusing on the most productive mines would allow energy

companies to generate an appropriate return on investment, one that will ensure time for more

profound restructuring in times of unfavourable market conditions.

• If restructuring in the mining industry fails, the potential transfer of the costs of upkeep

of unprofitable mines from the energy sector onto citizens would mean that every

household would spend an additional PLN 220-360 (ca. EUR 50-85) a year. If the costs

of the permanent deficit were to be financed by consumers of electricity or coal, their prices would

need to increase by PLN 20-30 (ca. EUR 5-7) per MWh and PLN 180-290 (ca. EUR 40-70) per tonne.

However, this would probably involve breaching EU regulations not only in the area of energy and

climate but also state aid rules. That is why making citizens cover the costs

of maintaining the mining industry by consolidating the energy and mining sectors is neither

a desirable, nor a realistic alternative to the actual restructuring of Polish mines.


6

• In the next two decades, energy companies will need to invest several hundred billion zloty

in modernising infrastructure. Otherwise, they will not only become uncompetitive and lose their

market position but may also become a threat to the energy system and the entire economy. Their

investment capacity is also limited and covers 40% to 70% of the investment needs of the Polish energy

sector. In this situation, engagement in unprofitable mining operations may materially deteriorate the

development outlook for the state-owned energy companies. Moreover, if restructuring the mines that

have been taken over is unsuccessful, this may pose a threat to the survival of some of the energy

companies.

• Losses anticipated by the owners of energy companies involved in saving the mining industry are likely

to range between a few percent of market capitalisation, if coal prices increase and

the restructuring process is successful, and over 50% (or 100% in the worst case scenario)

if the prices of this commodity remain low or if the restructuring process is unsuccessful. Also from this

perspective, a viable, ambitious restructuring strategy is crucial.


7

Recommendations

• The plans of restructuring mining companies should assume closing down the most unprofitable mines.

This would increase the chances of success of the entire process and ensure that energy companies

benefit from the consolidation initiatives. The goal of restructuring should not be maintaining the

current production volumes, but rather establishing a new permanent balance in the Polish mining

industry for the next 20 years. The new balance should assume a much smaller scale of mining

operations, which would be based on solid economic foundations.

• It is important to avoid direct acquisitions of unprofitable mines by energy companies. Capital

involvement of energy companies in mining enterprises (i.e. taking part in their recapitalisation) limits

the extent of potential losses, provided that it is one-off, relatively small and accompanied by an

economically sound restructuring scheme. Considering the negative experiences so far with the

functioning of state-owned mining companies and the risk of a permanent stagnation of coal prices, it is

worth considering the privatisation of the restructured mining enterprises. In this scenario, the energy

sector could act as a temporary investor overseeing the restructuring process and reselling

(with a profit) profitable mining assets to private investors.

• The potential recapitalisation of mining companies by the energy sector or any other investor should be

conditional on presenting a realistic profitability improvement plan, going beyond

the one presented during the PGG negotiations. It is important that the execution of the plan

by the company should be monitored and additional remedial actions should be taken, if needed (e.g.

further production reduction, deeper restructuring of employment or closing down the unprofitable

mines).

• Poland’s energy policy should aim for adjusting the production of electricity from coal to reflect the

declining potential of profitable coal mining. A paradigm in which energy security has to be based on

domestic mining needs to be confronted with the reality: the scale of economically justified mining

operations is already much below the level actually maintained, which translates to huge losses. The

problem will get worse in the future, as employees will put more pressure on wage raises and suppliers

will increase their prices.

• This will call for a gradual technological diversification of power and heat generation. The pace

of changes should reflect the declining hard coal production in Poland. According to the presented

estimates, hard coal mining is expected to become uneconomical in Poland in the next 20 years. Given

the various options for ensuring energy security with own resources, it is important to consider the

potential of domestic renewable energy sources and investing in improving energy efficiency.


8

bill

ion

PLN

'15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

20

30

20

31

20

32

20

33

20

34

20

35

20

36

bill

ion

PLN

'15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

20

30

20

31

20

32

20

33

20

34

20

35

20

36

Assumptions for mining and employment in the PGG restructuring scenario

Scenario

Production, in million tonnes

Employment, in thousands

Permanent change in salaries?

2015

2018

2036

2015

2018

2036

No restructuring

26

26

28

36

39

39

No

April agreement

30

22

No

Initial business plan

30

22

Yes

Deep restructuring

15

15

13

10

Yes

Source: WiseEuropa, own calculations

PGG’s equity capital by restructuring scenario and coal price forecasts

Gradual increase in coal prices 14

12

Stagnation of coal prices 6

5

r=3%

10

r=7% 4

8

3

6 r=3%

2 4

2 .. r=0% 1

r=0%

0 0

— No restructuring — April agreement — Initial business plan — Deep restructuring



9

Ch

ange

s in

mar

ket

cap

of

ener

gy c

om

pan

ies

Ch

ange

s in

mar

ket

cap

of

ener

gy c

om

pan

ies

Assumptions for mining production and employment in the scenario assuming restructuring of PGG, JSW and KHW mines

Scenario


Employment, in thousands

Permanent change in salaries?

2015

2018

2036

2015

2018

2036

No restructuring

54

56

49

76

79

68

No

Shallow restructuring

65

42

No

Moderate restructuring

65

41

Yes

Deep restructuring

32

31

33

23

Yes


Estimated impact of the takeover of PGG, JSW and KHW mines on the market capitalisation of energy

companies by mining industry restructuring scenario and the coal price projections

20%

Gradual increase in coal prices

+10%/+15%

Stagnation of coal prices

0%

0%

-20%

-40%

-60%

-80%

-100%

-78%

/-53%

No

restructuring

-17%/-11%

Shallow

restructuring

-5%/-3%

Moderate

restructuring

Deep restructuring

-20%

-40%

-60%

-80% -100%

-85%

/-100%

No

restructuring

-65%/-44%

Shallow

restructuring

-49%/-33%

Moderate

restructuring

-10%/-7%

Deep

restructuring



10

1. Introduction

2016 is a crucial year for the Polish mining industry.

The end of the commodity boom on the global market and the EU

regulations that prevent subsidising unprofitable mines revealed

the massive scale of structural problems the industry faces, forcing decision-

makers to make the effort and restructure it. Since late 2014, a few of the

less productive mines were transferred to the Mine Restructuring Company

and employment in the industry dropped significantly, which triggered a

noticeable increase in productivity.

However, the actions taken so far are far from satisfactory. Regaining financial stability by the sector requires

making major investments and cutting costs. As the mining sector has no available resources, energy

companies are to become involved in the restructuring process. The Polish energy sector needs to face the

challenge of financing the capital-intensive modernisation of the ageing electricity and heat generation and

distribution infrastructure as also needs to comply with the climate, energy and environmental requirements

of the European Union.

In this report we attempt to present the results of merging the coal mining and the energy sectors

in Poland. To this end, we evaluate the perspectives ahead of the just established Polska Grupa Górnicza,

which is to take over the assets of Kompania Węglowa, and we consider the results

of the broader consolidation scenario, assuming vertical integration of also the mines that are currently

owned by Jastrzębska Spółka Węglowa and Katowicki Holding Węglowy. We also consider various

restructuring scenarios, analysing how they may affect the investment capacity of energy companies and

their valuations, and indirectly the wallets of consumers and taxpayers.

The analysis starts with a brief overview of the methodology. In the next three chapters we describe the

outcomes of the individual scenarios of consolidating the coal mining and energy sectors and

we also analyse the sensitivity of the obtained results to changing market conditions. The last chapter

contains a summary of the analysis and recommendations.


11

2. Methodology

2.1. Scope of the analysis

This report is an analysis of the possible options for consolidating the coal mining and energy sectors. The

first scenario assumes taking over mines by a special purpose vehicle (SPV) whose shares are acquired by

energy companies. This scenario corresponds to restructuring of Kompania Węglowa (KW) by forming Polska

Grupa Górnicza (PGG) and recapitalising the new entity by state-controlled energy concerns, which became

its shareholders. As the key elements of this transaction are publicly known, it was possible to run an analysis

focused on companies involved in it. An alternative approach to consolidation of the domestic energy and

mining sectors is taking over individual mines and mining companies by energy companies. It is important

to stress that the establishment of the PGG does not exclude this step in the future. It may be introduced in

the event of restructuring of the JSW or the KHW, or even the recently formed PGG, if the project fails. Given

the variety of consolidation options in this scenario (individual mines may be acquired

by different energy companies), we have analysed its effects for the entire sector. The results serve as an

estimate of the potential long-term burden of Polish mining on energy companies.

Box 1. Analysed scenarios of integrating the coal mining and energy sectors

Relying on the information about coal mining restructuring which was publicly available in early May 2016, we

have identified two consolidation scenarios:

• BASIC SCENARIO assuming acquisition of Kompania Węglowa mines by Polska Grupa Górnicza, recapitalised,

among others, by PGE, Energa and PGNiG Termika,

• ALTERNATIVE SCENARIO assuming acquisition of individual mines operated in April 2016

by Kompania Węglowa, Katowicki Holding Węglowy and Jastrzębska Spółka Węglowa by PGE, Energa, Tauron

and Enea.

Source: WiseEuropa research

We began our analysis with the evaluation of the impact of restructuring initiatives in mining on the

financial performance of mines and mining companies. That is why for every consolidation scenario (see Box

1) we have considered various changes in the profitability of assets acquired by the energy sector. The next

step was the evaluation of the impact of the consolidation process on the financial performance of energy

companies, including their investment potential. We have narrowed our analysis to the four leading Polish

energy groups: PGE, Energa, Tauron and Enea as well as three mining companies: PGG (formed from the

former Kompania Węglowa), KHW and JSW.


12

The last step was the estimation of the impact of the consolidation processes on investors (assuming that the

energy sector will not be compensated for the potential losses suffered), consumers (if losses are shifted to

end users) and taxpayers (if losses suffered by energy companies were to be covered directly or indirectly

from the state budget).

Diagram 1. Steps in the evaluation of consolidation of the energy and coal mining sectors

Effectiveness of

restructuring the

acquired mines

Impact on energy

companies

Impact on

investors,

consumers and

taxpayers


2.2. Mining restructuring process

The economic restructuring of coal mining is a complex process, whose effects can only be precisely

estimated by examining detailed data on geological conditions and organisation of mining in each mine

separately. If more aggregated data is examined, however, it is still possible to perform

the relevant calculations with a relatively small margin of error. Successful restructuring is mainly

conditioned on strictly economic factors, determining the costs and revenues of mining enterprises. The

former are mainly unit labour costs, which depend on employment level, extraction productivity and miners’

salaries. An important factor on the cost side is also the scale of modernisation investments and the quality

of management that affect all other mining costs (e.g. effective use of outsourced services). Mining revenues

are predominantly conditioned by global and domestic market forces that cause coal price fluctuations, as

well as by changes in demand for this fuel from the energy sector.

Based on these factors we can evaluate the relation between mining profitability and the chosen

restructuring scenario as well as external factors, such as the market price of coal. The calculations require

a limited number of parameters and a few assumptions about their future evolution. The necessary data is

available in the financial statements of mining enterprises and other publicly available sources, disclosed by

the companies or other stakeholders, including unions and the Ministry of Energy. A particularly important

data source is the business plan of Polska Grupa Górnicza (KW 2016) supplemented with information on the

directions of restructuring, expected changes in employment and the anticipated cost reduction in mines.


13

Diagram 2. Estimation of the impact of restructuring and external factors on the profitability of mines

Restructuring External factors

Overall improvement in

management

Other costs

Changes in labour

productivity

Changes in salaries

Labour costs

Coal price

Trends on the global

coal market

Scale of investments Amortisation and depreciation

Profit/loss on coal sales

Financial costs

Liabilities from

previous years

Cost of debt

Pre-tax net profit/loss


Taking into account considerable uncertainty regarding the outcomes of restructuring initiatives in each

option of integrating the energy and mining sector, we analyse four scenarios:

• Moderate restructuring (for PGG – Initial business plan), consistent with the initial plans

of the government regarding the sector’s restructuring. It assumes retaining all mines, salary cuts and

significant improvement in labour productivity, achieved mainly through significant reduction in

employment.

• Shallow restructuring (for PGG – April agreement), assumes taking similar steps as in the moderate

restructuring scenario, yet maintaining the miners’ remuneration scheme, with a temporary withdrawal

from paying the so-called fourteenth salary until 2017.


14

• Deep restructuring assumes a significantly greater improvement in profitability than in

the Moderate restructuring scenario, thanks to closing down of the least efficient mines and investment

in the most productive assets.

• No changes, maintaining status quo ante, i.e. maintaining all mines without any productivity

improvements.

The analysed period is 2016–2036. A number of common assumptions regarding the market

environment of the mines have been made for all the scenarios (Table 1).

Table 1. Common assumptions for all analysed mine restructuring scenarios

Parameters – levels

Depreciation rate

20%

Cost of debt

7%

Parameters – dynamics (average annual growth)

Coal price, 2016–2036

+1.9% (chapters 3 and 4) +0.4% (chapter 5)

Salaries – after completion of restructuring

+3.2%

Other unit mining costs (excluding depreciation) – after completion of restructuring

+2.4%

Labour productivity improvement dynamics* – after completion of restructuring

+1.6%

Source: WiseEuropa research; *not applicable in the “No changes” scenario

The assumed future coal price dynamics is based on the most recent forecasts of the World Bank

(2016a and 2016b) for the global market up to 2025, which we have extrapolated onto

2026–2036. The January forecast has been assumed as the baseline. It predicts a moderate increase in the

prices of coal in the long-term, similarly to other forecasts from last year (e.g. DECC 2015). The forecast

published by the World bank in late April 2016 assumes stagnation of the coal prices

in the long term. It reflects the convictions that are voiced ever more frequently that in the next few years

the supply of coal will exceed demand globally, which should prevent coal prices on the global market to

increase again (e.g. IMF 2016). We assume coal price stagnation until 2036 in order

to perform the sensitivity analysis of the effects of consolidating the energy and mining sectors –

the results are presented in Chapter 5.

We assume that after a couple years of restructuring salaries will start increasing again,

in line with the overall trend of improving productivity in the economy. This assumption

is based on the anticipated wage pressure which will be exerted on the mining sector

by the rest of economy, especially the manufacturing sector, which employs similarly-qualified staff

(see Bukowski et al. 2015). A necessary condition to handle this pressure by the mining sector is to gradually

improve labour productivity in the restructured mines.


15

We assume that this will be achieved by constantly introducing organisational and technical improvements,

coming as a result of the appropriately high investments. This requires reaching

the sufficient EBIT profitability level. Improving labour productivity will slow down the increase

in other costs not associated with the consumption of fixed capital (especially outsourced services), which

will cause them to increase slower than average salaries in the economy.

Subsequent chapters contain more detailed information about the size of the necessary investments,

improving mining productivity, shifts in salaries and the mining output during restructuring in each

of the analysed scenarios of consolidation of the mining and energy sectors.

2.3. Impact of the consolidation on energy companies

and investors

An analysis of the effects of each option of integrating the coal mining industry and the energy sector in the

light of several different restructuring scenarios in the industry allows to determine

the cash flows and Net Present Value (NPV) of the investments in mining companies and mines from the

investor’s perspective. This allows to evaluate the impact of consolidation on the key financial parameters of

energy companies, their investment capacity and capitalisation (and therefore stock prices). The evaluation

includes the following:

• estimation in variants of the ranges of investment capacity of individual energy companies, when they

are not involved in restructuring the mining sector – the range depends, among all,

on restructuring the energy sector itself but also on external conditions, e.g. the shape of future

regulations or the market price of electrical energy,

• calculating the impact of cash flows generated through capital involvement in coal mining on

the investment capacity of energy companies, assuming that 40% of their profit will be allocated for

dividend payments and that the share of external financing reaches 50%,

• calculating the investment capacity of energy companies in different options and scenarios that assume

consolidation with mining.

Estimations are performed based on historical financial data and assumptions for

the development of the Polish energy sector up to 2036. The low option assumes stagnation of unit income

as a result of, among all, the prevailing low bulk prices of electrical energy and the absence

of additional supporting mechanisms, such as capacity markets or green certificates, and also maintaining

the present dividend policy in energy companies. The high option assumes constant increases in unit income

by 3% per annum (this corresponds to the forecasts presented in the draft 2050 Poland’s Energy Policy) and

increasing investments at the expense of dividends.


16

The impact of the consolidation on the capitalisation of energy companies is evaluated by comparing the net

present value of the investment in coal mining (calculated for a discount rate of r=7%) and their present

market value. This is how we estimate the impact that the fusion of the mining and energy sectors may have

on the assets of the shareholders of energy companies. It can be assumed that a part of this impact has

already been reflected in the valuation of energy companies, which has significantly dropped in 2015–2016,

among all under a wave of speculation regarding the prospects of the energy and mining sectors fusion. That

is why we present the impact of consolidation with the mining industry on energy companies’ capitalisation

in two variants: assuming valuations from March 2015 and March 2016. These can be treated as range of

values for the relative impact of the fusion on the stocks of energy companies.

2.4. Impact on consumers and taxpayers

Should the financial results of energy companies deteriorate as a result of consolidation with the mining

sector, there is a risk that some or all losses of the investors will be shifted to consumers or taxpayers. The

state, being at the same time a regulator and the co-owner of energy companies, may make attempts at

compensating for the costs of the failed restructuring of mines incurred by energy companies, motivating its

decisions, e.g., with the concern for the country’s energy security. For the purpose of this analysis, the cost

that meets this definition is the negative Net Present Value (NPV) of the investment, calculated for a discount

rate of 7%.

Diagram 3. Assessed possibilities of shifting the losses of the energy sector onto the citizens and

indicators of the potential support intensity

Support for the energy sector

Increase in coal

prices for

individuals

Additional fees for

electricity

Immediate

support from

the budget

PLN/tonne PLN/MWh PLN/household per

annum



17

We consider three possible options of shifting the losses of the integrated mining and energy concerns onto

the citizens. The first option is increasing the prices of coal for individuals, possibly through limiting the

import of coal from outside the European Union and competition on the domestic market. The second

option is to introduce additional fees in the prices of electrical energy by the regulator. The third option is to

provide support to the mining and energy companies directly from the budget. It is important to stress that

in all of the presented options, there is a major risk of breaching EU regulations on state aid and competition

protection. An attempt at introducing them would entail not only costs for the citizens but could also give

rise to a legal dispute with EU institutions.

Box 2. Key problems of the Polish hard coal mining industry

The crisis of the Polish hard coal mining industry results from a combination of supply-side and demand-side

factors, particularly the organisational and geological problems (as coal deposits are harder to reach), as well as

the slump on the global market for this commodity and the potential loss of significance in

the European and global energy mix. It is structural, not cyclical in nature, so restoring profitability to

the industry requires a deep restructuring, not only weathering the cyclical slump on the coal market.

Low mining productivity

The majority of Polish mines are several times less productive than mining companies successfully competing on

the global market. Extraction per employee is similar to the deeply unprofitable mines from Western Europe,

which are earmarked for liquidation. This results from organisational and technical issues as well as the absence of

investments in modernising coal extraction. What is more, the negative impact of the high labour intensity on the

profitability of Polish mining will only deteriorate with time. This results from the wage pressure, corresponding to

the gradual increase in salaries in the entire economy. The wealthier the country, the more productive mining

must be to help draw employees with appropriately high salaries while maintaining the profitability of operations.

The United States, having good geological conditions and boasting a very high extraction productivity, remain an

important coal producer (despite the current crisis and a series of bankruptcies of the local mining enterprises),

while coal mining in Western Europe has nearly disappeared.

Chart 1. Productivity in underground coal mines in Europe and the United States

USA 2012 –the worst 20%

USA 2012

United Kingdom 1981

United Kingdom 1991

United Kingdom 2012

Spain 2012

Germany 2012

France 1996–2000

Poland 2005–2012

Poland 2015

0 1000 2000 3000 4000 5000

extraction per employee (tonnes per year)

Source: Bukowski et al. (2015) and data of the Ministry of Economy


18

met

res

cont'd Box 2. Key problems of the Polish coal mining industry

Geological barriers – mining depth and coal quality

Despite the considerable coal deposits in Poland, its recoverable resources are much smaller. Given

the current production in Polish mines, their coal resources will quickly start depleting after 2020.

As the deposits are depleted, it will be necessary to mine coal at greater depths, even up to 1 km.

The average mining depth in Poland increases with time, reducing productivity and increasing costs.

Chart 2. Average mining depth in underground coal mines

0

250

500

750

1,000

1,250

Poland USA United Kingdom Germany

1989 2000 2011 2009 2009 2009

Source: Bukowski et al. (2015)

The quality of the extracted coal is also an issue. This particularly concerns the quality of fuel delivered to private

individuals. For example, the Polish Coal Retailers Chamber of Commerce estimates that only around 15% of the

commodity produced in Poland is of better quality than imported coal. Domestic coal contains much more total

sulphur than its Russian counterpart and also has more ash (Ney et al. 2004). This makes it more difficult to

compete on the market but also to limit import through quality regulations. At the same time, the rising

awareness of the high health costs associate with air pollution in Poland translates to falling social acceptance for

the usage of low-quality coal for heating.

Low prices of coal on the global market

Structural problems of the coal sector surfaced with the systematically falling coal prices on the global market.

They are presently at under 50$ per tonne. This puts pressure on the domestic market on which

a downward trend is visible. In accordance with the Industrial Development Agency data, the price of steam coal

sold to utility and industrial power plants in March 2016 was PLN 194 per tonne

(8.75 PLN/GJ), while it was 264 PLN per tonne three years ago (11.9 PLN/GJ). Global outlook assumes

no rebound of the coal prices any time soon, but instead permanent stagnation is considered possible

(see Chapter 5.1). This means that a boom on the domestic market of this commodity should not be expected as

well, and the only way to make mines profitable again is through cost reduction.


19

PLN

/GJ

Jan

'11

Jun

'11

No

v'1

1

Ap

r'12

Sep

'12

Feb

'13

Jul'1

3

Dec

'13

May

'14

Oct

'14

Mar

'15

Au

g'15

Jan

'16

mill

ion

to

nn

es

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

cont'd Box 2. Key problems of the Polish coal mining industry

Climate policy and energy sector transformation

In the long term, the main factor affecting the competitiveness of mining is the gradual tightening of

the climate policy coupled with the progressing transformation of the energy sector, not only on the domestic or

European but also global scale. Investments in low-emission energy sources and improving energy efficiency will

continue to limit the demand for coal. If the global demand for coal fails to increase dynamically, only the mines

with the lowest operating costs will manage to stay in the market. The Polish mines which will not be able to

radically improve mining productivity will remain permanently unprofitable.

Chart 3. Prices of Polish and Australian coal, 2011–2016

Chart 4. Hard coal production and consumption in Poland, 1990–2015

18 150

125 16

100

75

50

25

0

8 -25

— Polish Steam Coal Market Index

– sale to the energy sector

— Polish Steam Coal Market Index

– sale to the heat generation sector — Prices of Australian coal

n Domestic consumption

n Import

n Export — Domestic production

Source: own research based on Industrial Development Agency (ARP) and International Monetary Fund data

Source: own research based on Central Statistical Office (GUS) and Industrial Development Agency (ARP) data


14

12

10


20

extr

acti

on

per

em

plo

yee

(to

nn

es p

er y

ear)

in t

ho

usa

nd

s

3. Outlook for Polska Grupa Górnicza

3.1. Restructuring scenarios

The main parameter differentiating the four scenarios of how the Polska Grupa Górnicza (PGG) should

function in the future is employment dynamics. In the deep restructuring scenario we assume a nearly three-

fold drop in employment by 2018. It will primarily be a result of discontinuing extraction in certain mines,

where a permanent improvement in productivity is not possible. Afterwards it will continue to drop as a

result of the gradual increase in capital intensity of extraction in other locations, which entails a successive

improvement in labour productivity – it is expected to double by 2036. A similar, long-term upward trend in

productivity is also assumed in the April agreement and Initial business plan scenarios. However, in these

cases the scale of employment restructuring in the initial period is much lower, no mines are closed down

and the production remains high (28 million tonnes versus 15 million tonnes in the Deep restructuring

scenario). This comes at a price of much lower mining productivity and profitability. On the opposite end is

the No restructuring scenario, in which both coal extraction and employment are maintained

on a steady level, while labour productivity does not change.

Chart 5. Assumed improvement in mining productivity by PGG restructuring scenario

Chart 6. Employment by PGG restructuring

scenario

1500

1250

1000

750

500

250

718

1465

1262

718

40 39 39 39 36

35

30 30 30

26 26 25 20 15 13

12

10

5

22 22

10

0

2015 2018 2026 2036

0

2015 2018 2026 2036

• No restructuring

• April agreement

• Initial business plan

• Deep restructuring

n No restructuring

n April agreement

n Initial business plan

n Deep restructuring

Source: PGG business plan, WiseEuropa own calculations Source: WiseEuropa own calculations


21

In addition to the number of employees, the individual scenarios also differentiate between unit labour

costs. In the Deep restructuring and Initial business plan there is a one-off reduction in salaries in 2016–2017,

which will allow to better align remuneration and productivity. Additionally, assumed improvement in supply

management allows to bring down other units costs, mostly associated with outsourced services. The costs

of labour are also cut in the April agreement scenario, yet in this case the reduction in salaries has a

temporary character and only spans 2016–2017. This is a modification of the initial government plan to

restructure Kompania Węglowa, after negotiations with the trade unions: in accordance with the agreement

concluded in April 2016, salary cuts are only temporary and assume suspending the so-called fourteenth

salaries for two years.

Table 2. Cost assumptions by PGG restructuring scenario

Scenario

Labour cost in thousand PLN'15/employee

per year

Other costs (excluding depreciation),

PLN’15/tonne

2015

2018

2036

2015

2018

2036

No restructuring

81

81

142

110

110

169

April agreement

81

142

100

153


70

123

100

153

Deep restructuring

70

123

100

153


In all scenarios, after 2018 both salaries and other costs of mining will gradually pick up, driven by the

rising pressure on company costs from the broader economic environment. This is valid both for mining as

well as all other sectors of the economy, none of which is isolated from the other ones. A gradual increase in

efficiency (the volume of coal extracted per employee) is therefore a necessary condition to offset the

external pressure on costs in the sector. In all of the scenarios, this will require investing in modernisation of

mining. We assume that the target volume of investments per tonne of coal will be significantly higher than

at Kompania Węglowa, reaching over PLN 50 per tonne a year, consistent with the PGG business plan as well

as the experience of private mining enterprises (Bogdanka). We assume that the initial PGG capital will

amount to PLN 2.9 billion and that the company will take over and will be servicing the debt of Kompania

Węglowa in the amount of PLN 3 billion.

Improving labour productivity at PGG will not be limited to improving technical efficiency

(coal extraction per employee) but will also cover economic productivity. The latter will be influenced by the

price of coal on the global markets, which in the baseline price scenario will be gradually increasing as a

result of foreign companies limiting their production, adjusting supply to the global demand for coal.

However, the increase is relatively low, keeping the unit price in the entire assessed period near the multi-

decade average. This statement is of key significance for PGG’s ratio between income and costs, and thus for

its profitability in the medium term, as well as for the impact that the Group’s operations might have on

energy companies with equity interest in it.


22

PLN

'15/

ton

ne

Table 3. Assumptions for mining and investments in the PGG restructuring scenario

Scenario


Investments, PLN’15/tonne a year

2015

2018

2036

2018

2036

No restructuring

26

26

28

52

52

April agreement


Deep restructuring

15

15

Source: PGG business plan and WiseEuropa own calculations

An important distinguishing feature between the PGG’s deep restructuring and other scenarios is the

increase in the average sales price of coal through reduction in output. This results from limiting exports and

sales in the north of Poland. The entire lower volume of coal will be released onto

the local markets near the mines. This will ensure benefits from the proximity rent, measured as

the difference in the cost of transporting domestic and imported coal. We estimate that this will increase the

average price of coal sold by PGG by around 10%. Limiting excess supply of coal is,

in this case, as important as reducing mining costs.

Chart 7. Mining costs and coal sales prices by PGG restructuring scenario

450

400

350

300

250

200

150

100

50

0

2015 2018 2026 2036

Mining costs

Sales price

n No restructuring n Initial business plan • Deep restructuring n April agreement n Deep restructuring

—l

Other scenarios

Source: PGG business plan and WiseEuropa own calculations

The mining costs and income from the sales of coal determine the expected operating profit.

We estimate that under the presented assumptions PGG will generate a positive EBIT margin only in the

Initial business plan and the Deep restructuring scenarios. Failure to permanently withdraw fourteenth

pensions in the April agreement scenario will weigh on the financial performance of

the company by around a dozen zloty per tonne. This will yield a minimal profit on sales that neither

guarantees debt servicing nor offers a financial cushion as a safeguard against even a minor deterioration of

market conditions.


23

2015

2018

2026

2036

Deep restructuring

-30

45

53

66


12

14

20

April agreement

1

1

5

No restructuring

-37

-59

-97

In the event of no restructuring, PGG’s operating loss will increase from around 13% of income

to 30% in two decades. Zero or negative EBIT will require the company to receive permanent capital

injections from its owners or the company will be liquidated in a few years (or a few months,

in the absence of restructuring) due to depleting equity. In subsequent parts of the analysis we assume that

PGG shareholders will be systematically filling the potential financial gaps from their own profits. This

illustrates the case in which operating problems of today’s Kompania Węglowa are shifted to the companies

investing in PGG and how they are potentially multiplied as a result of market processes (beyond the

company’s control).

Table 4. EBIT per tonne of coal by PGG restructuring scenario

Chart 8. EBIT to sales ratio by PGG restructuring scenario

30%

20%

10%

18% 18% 19%

5% 5% 6%

0%

-10%

-20%

-30%

-13%

0% 0% 1%

-16%

-22%

-40%

-30%

2015 2018 2026 2036

— No restructuring

—l April agreement

—l Initial business plan —l Deep restructuring


On the opposite extreme is the Deep restructuring scenario, which, given the assumed market conditions

(increasing coal prices), will involve quick labour productivity improvement and a permanently positive

extraction profitability. This will be a result of focusing on the best deposits, reducing output and

employment as well as mechanising production. Companies investing in PGG restructured in such a way can

expect a high rate of return from the risk taken, given moderately positive price developments on the global

market. A prolonged downturn on the commodities market is a risk factor and, as we show in Chapter 5, it is

of key significance for the economic viability of the investment in coal mining in Poland after 2025, even

following a deep restructuring in the sector.

The Initial business plan scenario, which mirrors the government’s publicly voiced initial expectations of PGG,

allows to generate a positive operating result in 2017. The necessity to finance the investment and to service

debt makes the economic viability of the undertaking doubtful in the long term. The proposal offered a

positive net present value (NPV) to the investors only at very low discount rates (under 3%), which can be

considered acceptable from the social perspective but not from the investor’s point of view: as opposed to

bank deposits that offer a similar yield, this investment involves substantial risk.


24

NP

V, in

bill

ion

PLN

'15

b

illio

n P

LN'1

5

20

16

2

01

7

20

18

2

01

9

20

20

2

02

1

20

22

2

02

3

20

24

2

02

5

20

26

2

02

7

20

28

2

02

9

20

30

2

03

1

20

32

2

03

3

20

34

2

03

5

20

36

bill

ion

PLN

'15

N

PV,

in b

illio

n P

LN'1

5

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

20

30

20

31

20

32

20

33

20

34

20

35

20

36

What is more, a small scale of restructuring ultimately accepted in the April agreement scenario means that

energy company shareholders can expect the net present value of the investment in PGG to be negative

irrespective of the assumed discount rate. In Chapter 5 we show that this result will worsen if the downturn

on the global coal market proves permanent.

Chart 9. Cash flows from the investors’ perspective by PGG restructuring scenario

0.0

-0.5

-1.0

-1.5

-2.0

-2.5

-3.0

-3.5

n No restructuring

n April agreement




Chart 10. Net present value of the investment in PGG from the investors’ perspective by restructuring

scenario

0

-10

-20

Discount rate

0% 5% 7% 9%

-

-13

-17

Discount rate

0% 5% 7% 9%

10 9.2

8

6

4 3.3

-30

-40

-50

-24 2.2 2

0

-2 -4

2.1

1.2


-42

-5 -4 -3 -3

-0,6 -1,5 -1,1


25

In P

LN b

ilio

n

in P

LN b

illio

n

3.2. PGG’s impact on energy companies

To analyse the economic impact of investing in PGG for the major energy companies involved (PGE and

Energa), we assume that their share in the profits of the new entity or participation in loss coverage will be

proportionate to the initial contribution, namely PLN 500 million each. In the case of scenarios that assume

no or limited restructuring of the mines, PGG’s equity of PLN 2.9 billion (PLN 500 million of initial

contribution from Węglokoks and a PLN 2.4 billion capital injection by PGE, Energa, PGNiG Termika,

Węglokoks, TF Silesia and Fundusz Inwestycji Polskich Przedsiebiorstw) will not suffice to ensure sustained

operation. This means that it will be necessary to either continue subsiding PGG by energy companies or to

withdraw from maintaining all mines (or most of them) in the near future (deeper restructuring than

assumed in PGG’s business plan or the April agreement scenario). In this chapter we consider the outcome of

the first variant, namely permanently burdening the energy companies with maintaining coal extraction and

employment in PGG. In the second variant (no support from the energy sector), PGG will go bankrupt in

2023 if the April agreement is implemented, or in 2017 if not restructuring is carried out at all.

Chart 11. Estimated investment capacity of PGE and Energa in 2016–2036 by PGG restructuring scenario and developments on the energy market

200

180

120

160

140

100

80

60

40

20

0

PGE

Low variant High variant

PGE investment capacity in 2016–2036

Energa 50

45

40

35

30

25

20

15

10

5

0 Low variant High variant

Energa’s investment capacity 2016–2036

n n No investments in PGG — No restructuring — April agreement — Initial business plan — Deep restructuring


We estimate that investing in PGG without any restructuring initiatives being introduced would lower the

investment capacity of both PGE and Energa by around PLN 12 billion. Relative burden for each entity would

be different in view of the different scale of operations. PGE’s investment capacity for 2016–2036 without

involvement in the mining sector is estimated at around PLN 110 billion in the low variant (stagnation of the

company’s income, limited restructuring of costs and maintaining the current dividend policy), and PLN 180

billion in the high variant (increase in income by about 3% p.a., e.g. as a result of a capacity market

introduction, restructuring the costs of producing and distributing energy, increasing investments at the

expense of the dividend).


26

Ch

ange

in P

GE'

s in

vest

men

t ca

pac

ity

Ch

ange

in E

ner

ga's

inve

stm

ent

cap

acit

y

Analogous assumptions for Energa yield an investment capacity of PLN 31–43 billion by 2036. Therefore,

permanently absorbing some of the losses of unrestructured PGG would reduce PGE’s investment capacity

by 7–11% by 2036 and even up to 28%–39% in the case of Energa.

In the more optimistic scenario, the April agreement, PGG would be a lesser burden for the investors. We

estimate that investment capacity of both companies in this case would drop by around

PLN 1.4 billion (1% of the total capacity of PGE and 3–5% of Energa). The Initial business plan would be close

to neutral for both companies, but this result is subject to considerable risk: even if market conditions

deteriorate only slightly, the drop in investment capacity of both entities would be noticeable. Only Deep

restructuring, which assumes focusing on PGG assets that offer good prospects, allows both PGE and Energa

to achieve a positive return on capital and enables a slight increase in their own investment capacity by PLN

0.7 billion in a 2036 perspective. At the same time, this scenario leaves a relatively high safety margin,

reassuring investors from the energy sector that involvement in mining, provided a deep restructuring is

carried out, will not become a completely failed investment, even if coal prices do not rebound in the long

term (see Chapter 5.2).

Chart 12. Estimated impact of PGG on the investment capacity of PGE and Energa in 2016-2036 by restructuring scenario and developments on the energy market

PGE 2%

Energa

-2%

-4%

-6%

-8%

-10%

-12%

-1

-5%

-10%

-15%

-20%

-25%

-30%

-35%

-40%

-45%

-39%

-5%

-1% -28%

-1%

Low variant High variant Low variant High variant

n No restructuring n April agreement n Initial business plan n Deep restructuring


Greater impact of the assessed investment on Energa than on PGE results from the fact that both energy

companies contribute equally to recapitalisation of Polska Grupa Górnicza, despite the fact that PGE is

several times larger than Energa, has more profitable assets and generates better financial results. It is

interesting to note that the relatively good financial standing of PGE compared to the rest of the sector

entails greater investment capacity, which is why investing in PGG is much less risky for this company than for

Energa. PGE’s investment capacity would be considerably reduced only if no restructuring initiatives were to

be undertaken at PGG. Comparing the historical and current capitalisation of both energy companies with

the net present value (NPV) of the investment in PGG offers the same conclusion.

-11%

-1% -0,3%

0,6%

-7%

-1%

2%

-0,2% 0,4% 2%

-5% 0%

0%

5%


27

Ch

ange

in P

GE'

s ca

pit

alis

atio

n

Cap

ital

isat

ion

of

PG

E

Ch

ange

in E

ner

ga's

cap

ital

isat

ion

N

PV

of

the

inve

stm

ent

in P

GG

Ener

ga's

cap

ital

isat

ion

NP

V o

f th

e in

vest

men

t in

P

GG

Chart 13. Present capitalisation of PGE and Energa and net present value of the investment in PGG by restructuring scenario

PGE

Energa

March 2015 March 2015

March 2016

Deep

restructuring

Initial business

plan

April

agreement

No

restructuring

March 2016

Deep

restructuring

Initial business

plan

April

agreement

No restructuring

-0,2

-0,7

5

0,3

-10 0 10 20 30 40 PLN

billion


-8 -6 -4 -2 0 2 4 6 8 10 PLN

billion

One is led to believe that the significantly milder decrease in price of PGE stocks over the past 12 months

compared to Energa’s valuation reflects to some extent the fact that investors are less concerned that

permanent involment in PGG, even in the worst-case scenario, may threaten the existence of the enterprise.

In the case of Energa, the costs of permanently supporting ineffective mining operations at PGG would

exceed the present market value of the company. That is why introducing restructuring measures at PGG

is particularly important from Energa shareholders’ point of view. They should take into account that PGG

restructuring may fail and that continuing extraction at the expense of its owners would be very risky

for them, as the possible loss ranges between 65% and 100% of the company value. Keeping the mine

in the April agreement scenario is, from their perspective, problematic, exposing Energa shareholders to the

risk of losing 7–13% of the value of the company. In the Initial business plan scenario (one-off capital

injection in a fairly successful PGG restructuring), Energa’s market cap may drop by 2–4%. Yet, initiating

the process of deep restructuring at PGG mines may increase Energa’s value by even 4–6%.

Chart 14. Estimated impact of PGG on the market capitalisation of PGE and Energa in 2016-2036 by

restructuring scenario 5%

0%

-5%

-3%/-2%

+1%

20%

0%

-4%/-2%

+4%/+6%

-10%

-15%

-20%

-25%

-24%

/-17%

-40%

-60%

-100% /-65%

No restructuring

April

agreement


Deep restructuring

No

restructuring

April agreement


Deep restructuring


-1%

-13%/-7%

-80%

-100%

-20%

-30%

36

25

0,3

-0,2

-0,7

-6 -6

9


28

Our estimates for PGE, given the scale of its business, are more optimistic. The impact of PGE’s

investment in a totally unrestructured Polska Grupa Górnicza would reduce capitalisation by around 17–24%.

Assuming a restructuring effort in accordance with the April agreement scenario, the reduction would reach

2–3% and only 1% in the case of the Initial business plan scenario. A deep restructuring may add around 1%

to the company’s market cap.

3.3. PGG’s impact on consumers and taxpayers

Indirectly compensating energy companies for potential losses from restructuring PGG would require,

e.g., increasing the price of coal for retail customers or subsidising electrical energy production by taxpayers

or consumers. If status quo was to be maintained in Polska Grupa Górnicza mines, shifting costs onto coal

market consumers would increase by the prices by PLN 170 per tonne, and in the case of the April agreement

by nearly PLN 20 per tonne. The causes of such a strong effect are twofold. Firstly, generating net benefits for

energy companies requires increasing retail and wholesale coal prices, with the exception of coal used in the

energy sector. At the same time, if the state-controlled mines will act as monopolist, the prices of coal would

need to be increased by all domestic mining companies, and not only PGG. It should be noted that such

a significant increase in the price of domestic coal for consumers would be possible only if competition

from imports was blocked, which seems fairly unlikely.

Table 5. Shifting PGG restructuring costs onto consumers, by restructuring scenario

Average PGG restructuring costs in 2016–2036, PLN'15

per household annually

per tonne of coal

per MWh of energy

No restructuring

86

170

7

April agreement

10

20

0.8


2.7

5

0.2

Deep restructuring

-

-

-



29

It is a slightly more probable scenario, albeit still difficult to implement, to subsidise energy companies

indirectly by increasing the price of energy. We estimate that if support measures financed from electricity

bills were introduced for energy companies investing in PGG, the prices of electricity would rise by PLN 0.2–

7.0 per MWh, depending on the restructuring scenario. The option assuming support for energy companies

directly from the budget would increase its expenses by PLN 86 per household in the worst-case scenario.

It is important to stress that the presented estimates assume compensation only for PGE and Energa.

Compensating for the losses of all shareholders involved in PGG could consume nearly

PLN 140 annually per household, if no restructuring initiatives are taken.

Box 3. Financial viability of investments of energy companies in coal mines

In the public debate on restructuring the mining industry, the success criterion is often assumed to be driving

down the mining costs below the sales price of coal (obtaining a positive EBIT). However, from

the owner’s perspective, this does not mean generating a satisfactory return on the investment. A mining

enterprise not only bears the costs associated with its operating activity (extraction and sale of coal) but also

financial costs associated with commitments from previous years and new investment loans, taken on account of

restructuring. A sufficiently high rate of return needs to be obtained by the owner as well. Private investors

compare the return on capital employed against alternative investments (e.g. investments in competitive mining

enterprises, other sectors of the economy or other asset classes). When the state is the owner, it may accept a

lower rate of return in view of non-economic factors (e.g. intention to maintain status quo on the labour market in

the region or exercise direct control over primary energy sources). In the case of state-owned energy companies,

accepting a low rate of return is problematic for two main reasons:

• State Treasury is not the only owner of energy companies – they are listed on the stock exchange, so a

vast portion of their shares is held by private entities, including individual investors.

• EU regulations prohibit subsiding hard coal mining (see Box 4), which also includes companies controlled

by the State Treasury becoming involved in investments that are unattractive

for private investors.

Accepting a low, “social” rate of return by energy companies is not in the interest of energy company shareholders

and may be considered unlawful state aid by the European Commission. This means that not only the April

agreement, which yields losses, but also the profitable Initial business plan may be treated as unviable in

economic terms. What is more, investors do not base their decisions on one scenario of developments in the

industry but rather consider the opportunities and threats that any investment project needs to address. In the

case of mining, this means that it is necessary to take into account the real threat of a long-term stagnation of coal

prices (see Chapter 5), the risks of technical problems or rejection of labour cost cutting initiatives by trade unions.


30

bill

ion

PLN

'15

20

16

2

01

7

20

18

2

01

9

20

20

2

02

1

20

22

2

02

3

20

24

2

02

5

20

26

2

02

7

20

28

2

02

9

20

30

2

03

1

20

32

2

03

3

20

34

2

03

5

20

36

bill

ion

PLN

'15

20

16

20

17

2

01

8

20

19

2

02

0

20

21

2

02

2

20

23

2

02

4

20

25

2

02

6

20

27

2

02

8

20

29

2

03

0

20

31

2

03

2

20

33

2

03

4

20

35

2

03

6

cont'd Box 3. Financial viability of investments of energy companies in coal mines

Chart 15. PGG’s equity in various restructuring scenarios Baseline coal price scenario

14

12

Stagnation of coal prices 6

5

10

4

8

3

6

2 4

2 1

r=0%

0 0

— No restructuring — April agreement — Initial business plan — Deep restructuring

Source: WiseEuropa, own calculations; detailed description of the coal price stagnation scenario is presented in Chapter 5

In the light of these factors, only Deep restructuring of PGG and its assets is an opportunity for success of this

project, even in unfavourable market conditions. According to our calculations, given the baseline coal prices

scenario and implementation of the Deep restructuring scenario, the project would ensure a market rate of return

to the investors, and in a pessimistic scenario it would give then the necessary time to decide on deeper

adjustments. Less ambitious restructuring initiatives involve a high risk of not only generating low rates of return,

but also making the company insolvent within 2 to 7 years.


r=3%

r=7%

r=0%

r=3%


31

extr

acti

on

per

em

plo

yee

(to

nn

es p

er y

ear)

in t

ho

usa

nd

s

4. Sectoral integration

4.1. Restructuring scenarios

The entire initial investment of energy companies in the coal sector, if they were to become involved in the

acquisition (directly or indirectly) of not only mines owned by Kompania Węglowa, but also Jastrzębska

Spółka Węglowa and Katowicki Holding Węglowy, is estimated at PLN 5.5 billion and the acquired liabilities at

PLN 8 billion. Restructuring scenarios for the entire coal mining sector have been developed similarly to the

scenarios for Polska Grupa Górnicza. This means specifically:

• Closing down a number of mines and significantly limiting output in 2016–2018 in the Deep

restructuring scenario, which will allow a sharp increase in mining productivity by 2018.

• Continuously increasing labour productivity following 2018 thanks to higher mechanisation and gradual

reduction of employment in all scenarios, apart from No restructuring.

Chart 16. Assumed improvement in mining productivity by acquired mines restructuring scenario

Chart 17. Employment by acquired mines

restructuring scenario

1500

1250

1000

750

500

250

704

1319 1179 1161 714

80

60

40

20

65 65

33

0 2015 2018 2026 2036

0 2015 2018 2026 2036

—l No restructuring

—l Shallow restructuring

—l Moderate restructuring —l Deep restructuring

n No restructuring

n Shallow restructuring

n Moderate restructuring n Deep restructuring


76 79

77

56 55

27

68

42 41

23


32

Table 6. Cost assumptions by acquired mines restructuring scenario

Scenario

Labour costs, in thousand PLN’15/employee per year

Other costs (excluding depreciation),

PLN’15/tonne

2015

2018

2036

2015

2018

2036

No restructuring

84

88

152

113

113

174


88

152

104

159


79

136

104

159

Deep restructuring

76

135

105

160


We also assume that in the Moderate and Deep restructuring scenarios, in 2016–2018 remuneration will

be aligned with actual productivity in the sector by limiting other benefits paid to the miners.

Thereafter, the gradual increase in real salaries in the industry will follow the wage pressure from other

sectors of the economy, making it necessary to adequately increase productivity in the mining sector.

As in the case of PGG, it will be crucial to increase the scale of investment up to around PLN 55 per tonne

and introduce organisational changes to improve labour productivity. Major investments in the machines will

result in the growing mechanisation of production and a gradual reduction of employment in this sector.

Without these measures, assuming fixed mining output, achieving productivity levels that ensure increasing

real salaries would not be possible.

Table 7. Assumptions for mining and investments by acquired mines restructuring scenario

Scenario

Output, in million tonnes

Investments, PLN’15/tonne a year

2015

2018

2036

2018

2036

No restructuring

54

56

49

56

55



Deep restructuring

32

31

55

56


According to our calculations, if energy companies were to acquire the entire state-controlled hard coal

mining sector, they would need to accept that extraction profitability is only achievable in Moderate and

Deep restructuring scenarios. At the same time, only in the second case would it reach a level typical

for commercial entities operating in the sector. Our calculations indicate that chances for energy companies

to obtain a high operating margin (EBIT) through their involvement in restructuring coal mining are very slim.


33

2015

2018

2026

2036

Deep restructuring

-28

49

64

79


10

19

26


-1

6

10

No restructuring

-29

-46

-83

PLN

’15/

ton

ne

In the baseline coal price scenario, a positive EBIT may be expected in all variants that assume

a more or less far-reaching cost restructuring at the level of individual mines, yet only in the Deep

restructuring scenario the margin is a two-digit one and reaches the level expected by the investors and

lenders (see Box 3).

Chart 18. Mining costs and coal sales prices by acquired mines restructuring scenario 500

450

400

350

300

250

200

150

100

50

0

2015 2018 2026 2036

Mining costs

Sales price

n No restructuring n Moderate restructuring —l Deep restructuring

n Shallow restructuring n Deep restructuring —l Other scenarios


Table 8. EBIT per tonne of coal by acquired mines restructuring scenario

Chart 19. EBIT to sales ratio by acquired mines restructuring scenario

30%

20%

17% 19%

20%

10% 6% 7%

0%

-10%

-20%

-30%

0%

-11% -11%

2% 3%

-15%

-23%

2015 2018 2026 2036



—l Moderate restructuring


—l Deep restructuring

4%


34

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

20

30

20

31

20

32

20

33

20

34

20

35

20

36

bill

ion

PLN

'15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

20

23

20

24

20

25

20

26

20

27

20

28

20

29

20

30

20

31

20

32

20

33

20

34

20

35

20

36

bill

ion

PLN

'15

Particularly important from the investors’ perspective are net cash flows that may be expected following

vertical integration of coal mines and the state-owned part of the energy sector.

In the No restructuring and Shallow restructuring scenarios, throughout the analysed period they

undoubtedly will remain negative. In the latter case, however, the scale of cash outflow from

the energy sector to the mining industry is relatively small. In the Moderate and Deep restructuring

scenarios, energy companies can expect positive cash flows from funds invested in bailing out

the coal mining industry. However, similarly to the formation of PGG, only in the Deep restructuring scenario

can a positive net present value (NPV) on the investment be expected, regardless of

the discount rate that is applied. In the case of the Moderate restructuring scenario, a positive NPV

is achievable only if the investor expects a social (near “zero”) rate of return on the investment.

In the remaining options the result is unequivocally negative, which means that from the economic point of

view involving the energy sector in bailing out of the coal mining sector on a scale greater than in the case of

PGG makes sense only if it assumes very far-reaching restructuring initiatives. These should consist of a sharp

reduction of output and employment, technical and organisational changes and constant pressure on the

systematic improvement of labour productivity in the sector in the years to come. Otherwise, the expected

rate of return on the investment will be negative even if the prices of coal on the global markets increase,

which is assumed in this chapter. Economic analysis of the consolidation impacts under a permanent price

stagnation on the coal market is presented in Chapter 5.

Chart 20. Cash flows from the investors’ perspective by acquired mines restructuring scenario

0

-1

4 -2

2

-3

0

-4

-5

-6

n No restructuring



n Moderate restructuring


-2

-4

8

6

-6


35

NP

V in

bili

on

PLN

'15

NP

V, in

bili

on

PLN

'15

Chart 21. Net present value of the investment in the acquired mines from the investors’ perspective by restructuring scenario

0

-10

-20

-30

-40

Discount rate

0% 5% 7% 9%

-7 -7 -7

-22

-

Discount rate

0% 5% 7% 9%

25 22

20

15

10 9

-50

-60

-70

-80

5 3.8

0

-5

-1.1

6 4

-2.1

n No restructuring





4.2. Impact of sectoral integration on energy

companies

We estimate that the investment capacity of four public energy companies in 2016–2036 may reach

a maximum of PLN 200–300 billion, depending on the future market conditions, i.e. how quickly

the (real) prices of energy will be increasing and to what extent the individual enterprises manage to

restructure their operations. About half of these investments will need to be funded with the energy

companies’ own resources and half using external financing. The increase in the prices of the generated

energy does not need to result from the wholesale market developments. The increase in energy company’s

income per MWh may be partially associated with the supporting mechanisms, e.g. the capacity market, RES

support schemes, ETS revenue recycling, contracts for difference or other similar sources of financing

investment expenditure in the energy sector. It is important to note that at least some of the listed support

mechanisms (e.g. capacity market or contracts for difference) may prove inconsistent with EU state aid

regulations, which will limit the income and investment capacity of the Polish energy sector. That is why the

presented range should be viewed as the cap of the investment capacity of the four leading energy

companies that are currently controlled by the State Treasury. Similarly to PGG analysis (see Chapter 3), we

treat it as a reference point in the calculation of the impact of recapitalisation of coal mining operations on

the financial standing of the energy sector.

-67

-39

-27

-9

-2.8


36

in P

LN b

illio

n

Ch

ange

in t

he

ener

gy s

ecto

r's

inve

stm

ent

cap

acit

y

Chart 22. Estimated investment capacity of energy companies in 2016-2036 by acquired mines restructuring scenario

Chart 23. Estimated impact of the acquired mines

on the investment capacity of energy companies

in 2016-2036 by coal mining sector restructuring

scenario

350

300

250

200

150

100

50

0

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

-30%

-35%

-32%

-7%

-2% -1%

-5%

-22%


Energy sector’s investment capacity in 2016–2036

Low variant

High variant

n n No investments in PGG — No restructuring

— Shallow restructuring — Deep restructuring

— Moderate restructuring

n No restructuring n Shallow restructuring

n Moderate restructuring n Deep restructuring


The estimates are qualitatively similar to the impact that PGG will have on Energa. The Moderate

restructuring scenario is near-neutral for the investment capacity of state-owned part of the energy sector:

it will be reduced by around 1–2%, or PLN 4 billion over a 20-year period. Deep restructuring is a favourable

scenario for the energy sector. It would allow to increase its investment capacity by around PLN 12 billion,

i.e. around 4–6%. Partial failure of the restructuring process (the Shallow restructuring scenario) would bring

significant losses to the energy sector. The investment capacity would shrink by around 5–7% to around PLN

14 billion, which should be associated with the negative net present value of the fusion between the mining

and energy sectors, if the recovery process in the sector is halted. The no-change scenario, in which energy

companies take over mines without undertaking any of the necessary restructuring initiatives, would be

catastrophic for the energy sector. In this situation this will be to the detriment of the sector’s investment

capacity, causing its collapse by around 22–38% or PLN 64 billion.

4% 6%


37

NP

V o

f th

e in

vest

men

t in

m

ines

Ch

ange

s in

mar

ket

cap

of

ener

gy c

om

pan

ies

Cap

ital

isat

ion

Chart 24. Present capitalisation of energy

companies and present value of the investment

in acquired mines by coal mining industry

restructuring scenario


on the capitalisation of energy companies by coal

mining sector restructuring scenario

March 2015

March 2016

Deep

restructuring

Moderate

restructuring

Shallow

restructuring

No

restructuring

60

40

6

-2

-7

-31

20%

0%

-20%

-40%

-60%

-80%

-100%

-78%

/-53%

-17%/-11%

-5%/-3%

+10%/+15%

-50 -25 0 25 50 75

in PLN billion

No

restructuring

Shallow

restructuring

Moderate

restructuring

Deep

restructuring


An alternative way of looking at the consequences of the fusion between the mining and energy sectors

is to determine the possible change in the capitalisation of energy companies in reaction to the information

about the course of the restructuring process. Similarly to PGG case, the only scenario that would increase

market caps is Deep restructuring (value increases by around PLN 6.7 billion, i.e. 10–15%). The Moderate

scenario would bring capitalisation down, although the drop would be limited (PLN 2 billion). The Shallow

restructuring scenario would cause a PLN 7 billion (i.e. 11–17%) drop of the initial value of energy

companies. Integration with the mining industry that permanently generates very high losses is an

exceptionally dangerous option. According to our estimates, if restructuring of mining assets was not

possible, e.g. blocked for political reasons, the value of energy companies listed on the WSE would decrease

by 53-78%.


38

4.3. Impact of sectoral integration on consumers

and taxpayers

Similarly to the already analysed scenarios concerning PGG, one of the methods of compensating for the

losses arising out of the involvement of energy companies in the coal mining industry restructuring would be

to shift the burden onto the end consumers of coal or electrical energy, or the citizens (taxpayers).

In Table 9 we present detailed calculations for the deficient restructuring scenarios. In the Moderate scenario

the ensuing costs for an average household are limited, at around dozen zloty a year. In the Shallow

restructuring scenario they reach nearly PLN 50, and in the most pessimistic No restructuring scenario – over

PLN 220 a year per household.

Table 9. Shifting acquired mines restructuring costs onto consumers, by restructuring scenario

Average acquired mines restructuring costs

in 2016-2036, PLN'15


per tonne of coal

per MWh of electricity

No restructuring

223

177

19


48

38

4


14

11

1.2

Deep restructuring

-

-

-


Box 4. Investment challenges ahead of the Polish energy sector

Environmental regulations – IED directive and BAT conclusions

Directive 2010/75/EU of the European Parliament and of the Council of 24 November 2010 on industrial emissions

(the so-called IED) entered into force on 6 January 2011. The standards for harmful emissions concern, inter alia,

coal and gas power generation. Regulations for the existing installations found in the IED directive came into effect

on 1 January 2016. In view of the considerable costs of adaptation of the Polish energy sector to the requirements

of the Directive, the so-called derogations have been introduced, allowing to postpone the obligation to comply

with the IED standards. One of such mechanisms in the Transitional National Plan (PPK), which will remain in force

between 1 January 2016 and 30 June 2020. Facilities subject to the PPK will comply with their annual emission

limits. Another example of an alleviating mechanism is exemption from IED standards for installations which

in 2016–2023 will operate for up to 17,500 hours and will subsequently be liquidated. Slightly less strict emission

standards were also permitted for peaking power installations (operating under 1,500 hours a year). Introduction

of derogation mechanisms allowed to spread investment expenditure over a period of time.


39

cont'd Box 4. Investment challenges ahead of the Polish energy sector

Table 10. Key EU environmental standards for the energy sector and their impact on the Polish

energy sector

Regulation

Regulation timeframe

Impact on the Polish energy

sector

IED IED derogations:

Since 1 January 2016

In 2012–2015 the investment expenses on

making facilities IED-compliant amounted to around PLN 3 billion and another PLN 1

billion is forecasted for 2016–2020 (Masłowska 2015).

Installations benefiting from derogations will need to comply with the IED standards

once the exemption expires.

Transitional National Plan (PPK)

1 January 2016 – 30 June 2020

Exemption from IED standards for installations operating up 17,500 hours between 2016 and 2023, which will subsequently be decommissioned

1 January 2016 – 31 December 2023

BAT conclusions – regulations concerning Large Combustion Plants (LCP)

4 years after publication in the Official Journal

of the EU Estimated compliance

deadline – by 2021

Stricter emission standards as compared to the IED standards – estimated costs of modernisation resulting from the BAT

conclusions – around EUR 3 billion (TGPE 2015).


The main cause of adopting the IED was only partial meeting of the objectives of the 1996 Council Directive

concerning integrated pollution prevention and control (IPPC). One of the reasons for the failure was insufficient

use of the BAT reference technologies. The term BAT denotes Best Available Techniques which have been defined

as the most effective and the most advanced technology and methods of doing business, used as the basis for

setting emission limits to prevent pollution or, if that is unfeasible, to reduce emissions and their impact on the

environment. Imprecise regulations have been mainly to blame for the irregularities in implementing BAT, coupled

with excessive flexibility in issuing integrated permits as well as the unclear role of BAT reference materials, the so-

called BREFs (Best Available Techniques Reference documents), intended to exchange information between

member states and the relevant industry sectors. BREFs contain information that help set the terms of integrated

permits but were not binding laws. In view of the unsatisfactory functioning of this system, the work has been

initiated on BAT conclusions, which contain the most important information from BREFs. They will be adopted by a

decision of the European Commission, which means they will become legally binding. The introduction of BAT

conclusions will tighten the standards for emissions of many substances, including SO2, NOx, particulate matter and

mercury. The standards will also include substances whose emission has not yet been regulated directly. This may

require additional investments in emission reducing technologies, also in the case of power plants which have

been already modernised to meet the IED requirements regarding sulphur or nitrogen oxides.

BAT conclusions regarding large combustion plants are to be published at the turn of 2016 and 2017,

and the deadline for making installations compliant with their requirements is 4 years following publication in the

Official Journal of the EU. This means that it will most likely be necessary to make all conventional power plants

compliant with the new emission standards by 2021. This involves investments ranging from a dozen or so to

several hundred million zloty per power plant. According to Polish Power Plants Economic Society (TGPE 2015), the

cost of modernising the Polish energy sector to comply with the BAT requirements is around EUR 3 billion.


40

in P

LN b

illio

n

cont'd Box 4. Investment challenges ahead of the Polish energy sector

2030 climate and energy objectives

The 2030 EU climate policy objectives adopted in October 2014 assume a 40% reduction in greenhouse gas

emissions, 27% share of RES and a 27% improvement in energy efficiency. The European Commission assumes that

by 2050, greenhouse gas emissions are to be reduced by 80% relative to 1990. In the case of the Polish energy

sector, the reduction target under the Emission Trading System (ETS) will be decisive. ETS does not assume

emission limits on national level but a common limit for Europe has been set, which in 2030 will be 43% lower

than in 2005. Every member state has a certain degree of flexibility in managing its energy sector but they need to

take into account the forecasted price growth of CO2 emission allowances purchased by power plants under the

ETS. At least half of the proceeds from the auctions of rights sold by member states (including Poland) should be

allocated to support low-emission modernisation.

Less wealthy countries of the EU, including Poland, can take advantage of additional, special mechanisms

supporting transformation. In 2021–2030 these will include the Modernisation Fund (additional pool for

investments in low-emission solutions) and derogation for the energy sector (free allowances granted in exchange

for modernisations investments).

Chart 26. Investment expenditure in the Polish energy sector by 2030 for various levels of

greenhouse gas reduction, in PLN billion

450

400

350

300

250

200

150

100

50

0

15% 20% 30% 40% 45% 50% Emission

reduction in 2030

n Necessary investment expenses Investment capacity of PGE, Energa, Tauron and Enea (MIN)

Investment capacity of PGE, Energa, Tauron and Enea (MAX)

Source: EY estimates (Poręba 2016) and WiseEuropa

Therefore, the Polish energy sector is not obliged to meet any GHG reduction targets until 2030. However, if

domestic energy companies are to avoid the loss of competitiveness as a result of increasing prices of emission

allowances in the long term, they must invest in reducing greenhouse gas emission on at least a similar scale (and

in a similar way) as the rest of the EU. According to the most recent estimates, achieving 40–45% emission

reduction (comparable to the overall lowering of emission cap under the ETS) will require Polish energy sector to

invest around PLN 320 to 360 billion until 2030, with the key role played by expenditure on RES installations

(Poręba 2016).



41

USD

’10/

ton

ne

19

70

19

73

19

76

19

79

19

82

19

85

19

88

19

91

19

94

19

97

20

00

20

03

20

06

20

09

20

12

20

15

20

18

20

21

20

24

20

27

20

30

20

33

20

36

5. Consolidation during permanent

stagnation on the coal market

5.1. Forecasted stagnation of coal prices

On 26 April 2016, on the date of forming Polska Grupa Górnicza, the World Bank published its updated long-

term forecasts for the commodity prices, including coal (World Bank 2016b). Coal price forecasts from the

beginning of the year were revised downward, with the report pointing out a high probability of a long-term

stagnation on the coal market. It will result both from demand-side factors (lower demand from China,

decreasing coal use under climate policies, replacing coal with gas, whose prices are falling) as well as supply-

side factors (high mining potential, weakening of the currencies of coal exporters).

Chart 27. Prices of Australian coal in 1970–2015 and forecast for 2016–2036

(USD per tonne, fixed prices from 2010)

140

120

100

80 68

60 54 50

40

20

0

n Historical data n Baseline scenario n Price stagnation scenario

Source: Source: World Bank (2016a and 2016b) and WiseEuropa own calculations

Baseline scenario for coal prices adopted in the previous chapters has been formulated based on

previous forecasts of the World Bank. It corresponds to the assumptions adopted by the Polish government

regarding the success factors in the process of restructuring coal mining. An analysis drawn up based on this

input allows to evaluate the internal consistency of the Polska Grupa Górnicza investment project,

accompanied by the question about the role of optimistic market sentiment for the achieved results.

Subsequent signals coming from the market indicate that the evaluation of the perspective for the

consolidation of Polish mining and energy sectors requires analysing the effects of a permanent coal price

stagnation, which is the focus of this chapter.


42

2015

2018

2026

2036

Deep restructuring

-30

37

7

-29


4

-28

-66

April agreement

-7

-41

-81

No restructuring

-45

-101

-183

5.2. Outlook for PGG under stagnation of coal prices

From the point of view of the mining sector, the pressure on costs comes mainly from salaries in

the 2036 perspective. They remain under the control of an enterprise for a short time only.

In the mid- and long-term, salaries in any industry sector are determined by salaries in other sectors, e.g.

manufacturing or services. Therefore, meeting the government’s expectations which assume converging in

terms of development to the European average within two decades will require Polska Grupa Górnicza to

double the real salaries of its employees by 2036. This will not be possible unless every tonne of coal sold

generates income significantly higher than the costs of labour and mining-related outsourced services. In

view of the above, a sine qua non condition for the company to continue operating in the years to come will

be to constantly improve productivity, by gradually increasing the volume of coal per miner or through the

increase of the (real) unit cost of this commodity on the global markets.

Table 11. EBIT per tonne of coal at PGG under stagnation of coal prices

Chart 28. EBIT to sales ratio of PGG under stagnation of coal prices

20%

0%

-20%

-40%

-60%

-13%

15% 2%

-3%

-20%

3%

-12% -18%

-44%

-11%

-28% -34%


-80%

-100%

-77%

2015 2018 2026 2036


—l April agreement

—l Initial business plan


The pessimistic (from the perspective of the mining industry) outlook for coal prices presented

in the April forecast by the World Bank is also of key significance for the evaluation of the financial standing

of PGG in the next decade. In this situation, we conclude that not only the No restructuring scenario but also

the April agreement one will not suffice to achieve a positive EBIT margin over the forecast horizon. In this

respect, the Initial business plan scenario would offer only slightly better results, allowing for 2 to 3 years

of positive operating income. Only the Deep restructuring scenario allows to achieve a sufficiently high level

of technical productivity to ensure good operating results of PGG over around a decade, without any deeper

(than the one assumed in the scenario) restructuring of its mining assets and employment. However, this

state would be temporary, and further steps, including an additional reduction in output and employment,

would become inevitable.


43

NP

V, in

bill

ion

PLN

'15

NP

V, in

bill

ion

PLN

'15

From the investor’s perspective, this would mean that in the context of stagnant coal prices, none of the

analysed scenarios guarantees a positive net present value. This is true for measuring NPV with the market-

based discount rate as well as if a more “social” rate is applied. In the case of the April agreement scenario,

net present value of PGG ranges between PLN -11 and -30 million, which is a clear indication that this variant

is very sensitive to external price risk. Therefore, it should be seen as difficult to sustain: if the stagnation of

coal prices continued for only 5 years, the company would relapse into insolvency (see Chart 15 in Box 3).

Avoiding such a possibility requires the initial restructuring of assets and employment to be much deeper,

along the lines of the presented Deep restructuring variant. Prolonged downturn on the coal market going

beyond the 2020 horizon would mean that even this scenario would be insufficient and a further reduction

of mining unit costs of the company, through limiting the scale and focusing on the most prospective

deposits, would become an economic necessity.

Chart 29. Net present value of the investment in PGG from the investors’ perspective under stagnation of

coal prices

0

-10

Discount rate

0% 5% 7% 9%

-11

Discount rate

0% 5% 7% 9% 5 0

-20

-30

-40

-50

-60

-70

-80

-67

-30

-37

-16 -19

-25

-5

-10 -15 -20 -25

-22

-2.9 -2.4 -2.3 -2.2

-8

-10 -12

n No restructuring

n April agreement




If we assume that investors will be burdened with covering potential losses of PGG in the low coal prices

scenario in proportion to their equity interest, one can expect that PGE’s investment capacity will contract by

4%–7% and Energa’s by 18%–25%, assuming the April agreement scenario. In the case of the Initial business

plan, the decrease would only be slightly milder: 3%–5% for PGE and 13%–18% for Energa. Only the Deep

restructuring scenario ensures a sufficient financial cushion accumulated at PGG over 2016–2024, so that the

total investment capacity of both companies over the 2036 horizon would drop only slightly (under 1% in the

case of PGE and 2%–3% in the case of Energa). In other words, in the event of a downturn on the coal

market, this scenario also offers a negative rate of return but it is low enough to make the impact on the

energy companies’ investment capacity relatively limited.

-13


44

Ch

ange

in P

GE'

s ca

pit

alis

atio

n

Ch

ange

in P

GE'

s in

vest

men

t ca

pac

ity

Ch

ange

in E

ner

ga's

cap

ital

isat

ion

C

han

ge in

En

erga

's in

vest

men

t ca

pac

ity

Chart 30. Estimated impact of PGG on the investment capacity of PGE and Energa in 2016-2036 depending on the developments on the energy market and under stagnation of coal prices

0%

-2%

-4%

-6%

-8%

-10%

-12%

-14%

-16%

-18%

-7% -17%

-5%

-0.7% -0.5%

-3%

-4%

-10%

0%

-10%

-20%

-30%

-40%

-50%

-60%

-70%

-18%

-25%

-60%

-3% -2%

-13%

-18%

-43%

Low variant High variant Low variant High variant

n No restructuring n April agreement n Initial business plan n Deep restructuring


The necessity to permanently recapitalise Polska Grupa Górnicza in the April agreement scenario and

low prices of coal would have a destructive effect on the market values of PGE and Energa.

We estimate that in the case of the former it would drop by 11%–15%, and in the case of the latter – by as

much as 41%–72%. This again means that investing in PGG by Energa might be a risky transaction for the

shareholders of the latter, unless the company would react in the next 2 to 3 years to the negative forecasts

for the prices in a similar way as described in the Deep restructuring variant. However, even in this case the

price risk in the coal sector may affect the value of energy companies, unless their shareholders are certain

that PGG will not postpone reacting to the permanent downturn on the coal market by taking radical

cost-cutting steps in the coming years.

Chart 31. Estimated impact of PGG on the market capitalisation of PGE and Energa in 2016-2036 under

stagnation of coal prices and in the absence of any major restructuring initiatives 0%

-5%

-10%

-15%

-20%

-25%

-15%/-11%

-8%/-3%

-2%/-1%

0% -20% -40% -60%

-51%/-29%

-4%/-3%

-30%

-35%

-40%

-37%

/-26%

No

restructuring

April

agreement

Deep

restructuring

-80%

-100%

-99%

/-100%

No

restructuring

-72%/-41%

April agreement

Initial business

plan

Deep

restructuring




45

The high sensitivity of the Polska Grupa Górnicza project to the scale of internal restructuring but also

to external conditions can be illustrated by computing the range of the necessary increases in electricity

prices, the retail price of coal for individual consumers or the scale of additional public levies that the citizens

of Poland would need to pay, if the company’s deficit were to be funded by the end consumers of energy,

households buying coal or taxpayers, respectively. In each case the costs are much higher than in the

baseline scenario, in which we assumed a moderate increase in the global coal prices over the 2036 horizon.

However, only in the case of the Deep restructuring scenario can we speak of a scale that would be

acceptable for the consumers and taxpayers. In particular, an attempt to cover cost of PGG losses, assuming

the April agreement scenario, and compensating for the low price of coal by households or enterprises

buying coal would trigger the increase of its price by over PLN 100 per tonne. The cost borne by the

taxpayers in this variant would reach over PLN 50 per household a year. All instances of shifting the costs

of restructuring PGG onto the citizens should be treated as hypothetical, as introducing such measures

in practice (see Box 5) is very unlikely.

Table 12. Shifting PGG restructuring costs onto consumers under stagnation of coal prices

Average PGG restructuring costs in 2016–2036, PLN'15


per tonne of coal


No restructuring

130

259

11

April agreement

54

107

5


38

76

3

Deep restructuring

6

12

0.5



46

10

0=

Max

18

50

18

60

18

70

18

80

18

90

19

00

19

10

19

20

19

30

19

40

19

50

19

60

19

70

19

80

19

90

20

00

20

10

Box 5. State aid rules for the coal mining sector

Subsidising unprofitable mines in the European Union is regulated at the community level. Tightening cooperation

with European states in this area dates back to the turn of the 1950s and 1960s. After

the post-war boom, the mining sector in Western Europe had to handle overproduction crises and address its low

competitiveness on the global coal market. The industry gradually reduced output and employment while

European economies were shifting towards imported coal or using alternative energy sources over domestic coal.

In early 2000s, mines in Western Europe extracted an order of magnitude less coal than half a century ago.

An analogous process, with a delay of a few decades, is currently taking place in Poland (Bukowski et al. 2015).

Chart 32. “Peak coal” in Western Europe and Poland

100

90

80

70

60

50

40

30

20

10

0

— United Kingdom — France — Germany — Poland

Source: Bukowski et al. (2015)

Present EU regulations regarding state aid result from the Council Decision of 10 December 2010

on state aid to facilitate the closure of uncompetitive coal mines. It permits subsidising mines only if they are

scheduled for closing down, by the end of 218 at the latest. When adopting these solutions, it was believed that

they will facilitate the process of phasing out coal mining in Western Europe and the perspectives for maintaining

coal mining in Poland without state aid were viewed as optimistic (Ecorys 2008). The decision to cease indefinitely

supporting unprofitable mines was based on two key premises: marginal significance of the subsidised mining

sector for satisfying the energy needs of the European Union and reorienting the energy policy towards supporting

RES and energy efficiency.

Sharp increases in the cost of mining in Poland coupled with a permanent collapse of the prices of this commodity

on the global market made many Polish mines permanently unprofitable. The present EU regulations in force

allow to soften some of the societal impact of closing down mines by spreading this process over time. As a result,

the laid-off miners can gradually retrain and an adequate support scheme can be prepared for the local economies

which rely on the mines that are being closed down. Postponing the decision to close down the individual mines

shortens this preparatory period, scheduled to end on 31 December 2018. Liquidating unprofitable mines after

this date, without a transitional period, can be chaotic and significantly worsen the prospects of finding

employment by the laid-off miners.



47

2015

2018

2026

2036

Deep restructuring

-28

39

12

-27


1

-28

-69


-10

-41

-85

No restructuring

-38

-93

-178

5.3. Sectoral integration under stagnation of coal prices

The examined scenario of integration of the coal mining sector (PGG, KHW, JSW) and state-owned energy

companies (PGE, Tauron, Energa and Enea) has a similar pattern of sensitivity to the condition of the global

coal market to the one described for PGG. In this case as well, only the Deep restructuring variant ensures

temporary resistance to low prices of coal. In the case of the Moderate restructuring scenario, mining

operations would become unprofitable at the operational level already as of 2018. The difference between

this variant and the Shallow restructuring option is symbolic at best and limited to the first few years. In the

long term, both scenarios end with an operating loss of around 26% to 33%, i.e. PLN 69–85 per each tonne of

coal extracted, which is nearly twice as much as today. The cost pressure is high enough for even

the Deep restructuring scenario to generate a negative EBIT in the long term if prices are stagnant. This

means that even far-reaching restructuring initiatives in the sector, including a significant reduction in mining

output, adequate reduction in employment and focusing resources on the most efficient deposits, will be

insufficient in the mid-term in the event of a global downturn.

Table 13. EBIT per tonne of coal at acquired mines under stagnation of coal prices

Chart 33. EBIT to sales ratio of acquired mines under stagnation of coal prices

20%

0%

-20%

-11%

14%

1%

-4%

-15%

4%

-11% -16%

-9%

-26%

-40%

-60%

-80%

-36%

-33%

-68%


2015 2018 2026 2036



—l Moderate restructuring


From the perspective of energy companies, this means that their potential involvement

in restructuring of the Polish mining industry is an economically risky project, even if a far-reaching

restructuring scheme is implemented swiftly (Deep restructuring). Much more limited efforts (Shallow and

Moderate restructuring) further increase this risk. Only a few years of coal price stagnation would deplete

the entire injected capital and the energy sector will once again face the dilemma whether

to continue the support or suspend it, which would result in bankruptcy of the coal mines.


48

NP

V, in

bill

ion

P

LN

'15

NP

V, in

bill

ion

P

LN

'15

Chart 34. Present net value of the investment in mines from the investors’ perspective under stagnation of coal prices

0

-20

Discount rate

0% 5% 7% 9%

-22

0

-10

Discount rate

0% 5% 7% 9%

-4.5 -4.2 -4.0

-40

-60

-80

-100

-120

-140

-118

-60

-65

-33 -33 -43

-20

-30

-40

-50

-46

-25

-20

-17

n No restructuring





An unambiguously negative net present value of the investment in the mining sector coupled with

a stagnation in the prices of coal and unreadiness to discontinue extraction would require the energy sector

to constantly subsidise the mines. This would unavoidably limit its investment capacity.

We estimate that it would drop by 3%–53%, depending on the restructuring scenario. Shallow and Moderate

restructuring would bring down the investment capacity by around 14%–27% and Deep restructuring by 3%–

4%. Therefore, only profound restructuring initiatives undertaken in 2016–2018 would secure enough time

for energy companies to react and align their strategy to the downturn on the coal market. It can be

expected that in other scenarios the negative impact of the unprofitable mines on energy companies would

be so great that the market value could plummet by up to several dozen percent and if no actions were taken

in the mining industry whatsoever, it could lead to a total loss of own economic value by the energy sector.

Table 14. Shifting acquired mines restructuring costs onto consumers, by restructuring scenario

Average acquired mines restructuring costs

in 2016-2036, PLN'15


per tonne of coal


No restructuring

362

287

30


185

147

15


140

111

12

Deep restructuring

29

23

2,4


-6.0 -27


49

Ch

ange

in t

he

ener

gy s

ecto

r’s

inve

stm

ent

cap

acit

y

Ch

ange

s in

mar

ket

cap

of

ener

gy c

om

pan

ies

Chart 35. Estimated impact of acquired mines on

the investment capacity of energy companies in

2016-2036 depending on the developments on

the energy market and under stagnation of coal

prices


on the capitalisation of energy companies under

stagnation of coal prices

0%

-10%

-20%

-30%

-40%

-50%

-60%

-20%

-27%

-53%

-4% 3%

-14%

-18%

-35%

0%

-20%

-40%

-60%

-80% -100%

-85%

/-100%

-65%/-44%

-49%/-33%

-10%/-7%


n No restructuring





No

restructuring

Shallow

restructuring

Moderate

restructuring

Deep

restructuring

The burden of bailing out the entire mining industry by the state energy sector would be much greater

than the burden of supporting Polska Grupa Górnicza by PGE and Energa. As a result, even hypothetical

initiatives balancing the burden on energy sector that involve increasing the wholesale price of electricity or

the retail price of coal would trigger greater increases than the ones estimated for PGG. Costs for the

taxpayers would also be increased, if the deficit in the mining industry was

to be remedied with subsidies funded with taxes. As previously, also in this case these estimates should be

treated as an illustration of the problem, since the options for actually providing such aid are very limited.


50

6. Summary

Is it a good idea to merge the Polish mining and energy sectors?

No, if the purpose is to maintain the present status quo in the mining

industry or run a shallow restructuring process. Successful consolidation can

only be ensured by deep restructuring measures implemented at mining

companies, involving not only employment and wage cuts, but also closing

down the least profitable mines.

Attempts at a partial restructuring of the mining industry with the energy sector’s support will

either result in wasting additional capital and shutting down coal mining in Poland altogether or

in permanently burdening energy companies with the cost of maintaining the ineffective mining operations.

In the latter case, the costs of inaction will be borne by the citizens, either through higher costs of coal,

electricity or heat, or by having to address the deteriorating security of energy supplies because of

underfunded distribution and generation infrastructure.

The long-term upward pressure on salaries in the economy and no prospects for a permanent rebound in

coal prices means that the costs of maintaining the ineffective mining sector in Poland will escalate.

The Polish energy sector cannot afford the costs of failing to implement restructuring initiatives in the state-

owned mining sector. In the case of energy companies whose financial standing is less sound, acquisition and

maintaining a vast portion of the ineffective coal mining sector might even lead to bankruptcy. This scenario

results in drastically lowered investment capacity of the energy sector in the coming decades, a critical time

for modernising the outdated infrastructure. This risk can only be mitigated through a deep restructuring of

mining assets, yet even then energy companies face the risk of losses or low returns on the investment.

Declarations by decision-makers suggest that they are aware of the fact that the current high costs of labour

cannot be maintained: mining industry restructuring plans assume productivity improvement, mainly by

reducing employment, yet salary cuts are also considered (e.g. by limiting the so-called fourteenth salaries).

However, the agreement with the trade unions reached in April 2016 which paved the way towards forming

Polska Grupa Górnicza is not a sufficiently consistent plan. A mix of cuts and limiting of other mining costs

provides a chances of achieving a positive EBIT margin on the sale of coal over the next few years, but may

prove insufficient in the medium term.


51

This is also a serious managerial challenge and the profitability of investment in mining companies remains

low. It is significantly below the commercially viable levels, which means a net loss for the entire economy

and for private shareholders of energy companies, who may expect that their capital will ensure a rate of

return significantly more attractive than bank deposits. Also, the “moderate” restructuring scenario is

susceptible to a number of risks: 1) rejection of employment or wage reduction initiatives by employees, 2)

further decrease or slower than expected increase in the prices of coal, 3) geological and organisational

barriers for improving mining productivity, 4) potential identification of illegal state aid. Materialisation of

any of these risks may directly lead to another crisis in the mining industry by 2018.

Efforts to bring mining enterprises on the verge of profitability while maintaining the majority of

the mines, even the ineffective ones, are thus very risky. In this situation, even despite

a considerable improvement in efficiency, the mines would permanently weigh on the energy companies

financial standing, as has been presented in the Shallow restructuring scenario (or April agreement in the

case of PGG).

Mitigating the risk of failed restructuring of the coal mining sector requires abandoning the notion that

production levels need to be maintained and unprofitable mines should not be closed at all costs. This would

not only make it more probable that the assumed improvement in extraction productivity is achieved but

also that a higher sales prices is obtained on the domestic market by solving the oversupply issue.

An additional benefit from the energy sector’s perspective is limiting the scale of the necessary investments

in restructuring the mining industry and an overall increase in the investment capacity in the sector, which

should be spent on modernising and diversifying Polish power plants. The presented calculations show that

only a deep restructuring, coupled with replacing the idea that output should be maintained at all costs with

the principle of focusing only on economically viable undertakings, are justified measures from the investors’

perspective.

If restructuring in the mining industry failed, the potential transfer of the costs of upkeep of unprofitable

mines from the energy sector onto citizens would mean that every household

would spend an additional PLN 220 to PLN 360 a year. If the costs of the permanent deficit

were to be financed by consumers of electricity or coal, their prices would need to increase

by PLN 20-30 per MWh or PLN 180-290 per tonne. However, this would probably involve breaching EU

regulations not only in the area of energy and climate but also state aid. That is why making citizens cover

the costs of maintaining the hard coal extraction by consolidating the energy and mining sectors is neither

a desirable, nor a realistic alternative to the actual restructuring of Polish mines.


52

Bibliography

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Commodity Markets, Washington, D.C.

World Bank (2016b), Commodity Markets Outlook – April 2016. Resource development in an era of cheap commodities,

Washington, D.C.

Bukowski, M., Maśnicki, J., Śniegocki, A., and Trzeciakowski, R. (2015), Polski węgiel: Quo Vadis? Perspektywy rozwoju

górnictwa węgla1 kamiennego w Polsce, WISE, Warsaw.

DECC (2015), DECC 2015 Fossil Fuel Price Assumptions, Department of Energy and Climate Change, London. Ecorys

(2008), An Evaluation of the Needs for State Aid to the Coal Industry post 2010, report for the European Commission,

Rotterdam.

Kompania Węglowa (2016), Polska Grupa Górnicza Business Plan, Information sheet No. 4/2016, Katowice. Masłowska J.

(2015), Analiza potrzeb inwestycyjnych polskiego sektora energetycznego związanych z wejściem w życie dyrektywy IED,

Rynek Energii – December 2015.

IMF (2016), Primary commodity price forecasts – February 2016, International Monetary Fund, Washington.

Ministry of the Economy [MG] (2015a), Informacja o funkcjonowaniu górnictwa węgla kamiennego we wrześniu oraz w

okresie styczeń – Septmber 2015, Warsaw.

Ministry of the Economy [MG] (2015b), Wnioski z analiz prognostycznych na potrzeby Polityki energetycznej Polski do

2050 roku. Appendix 2. to the Energy policy for Poland up to 2050, Draft – version 0.2, Warsaw.

Ney, R., Blaschke, W., Lorenz, U., and Gawlik, L. (2004), Węgiel kamienny jako źródło czystej energii w Polsce,

Międzynarodowa Konferencja Przyszłość węgla w gospodarce świata i Polski, Pub. GIPH, Katowice, p. 224–240.

Poręba S. (2016), Założenia do zmiany dyrektywy ETS – czy spakietowanie dyskusji nt. sektorów ETS i non-ETS może być

skutecznym środkiem do optymalizacji polskiej ścieżki redukcji emisji CO2, EY, Warsaw.

Financial statements of Jastrzębska Spółka Węglowa, PGE, Energa, Tauron and Enea for 2012–2015.

Financial statements of Kompania Węglowa and Katowicki Holding Węglowy for 2012–2014.

TGPE (2015), Ekonomiczne perspektywy funkcjonowania wytwarzania konwencjonalnego, Towarzystwo Gospodarcze

Polskie Elektrownie, Warsaw.


53

List of figures

Box 1. Analysed scenarios of integrating the coal mining and energy sectors 11

Box 2. Key problems of the Polish coal mining industry 17

Box 3. Financial viability of investments of energy companies in coal mines 29

Box 4. Investment challenges ahead of the Polish energy sector 38

Box 5. State aid rules for the coal mining sector 46

Diagram 1. Steps in the evaluation of consolidation of the energy and coal mining sectors 12

Diagram 2. Estimation of the impact of restructuring and external factors on the profitability of

mines 13

Diagram 3. Examined possibilities of shifting the losses of the energy sector onto the citizens and

indicators of the potential support intensity 16

Table 1. Common assumptions for all analysed mine restructuring scenarios

14

Table 2. Cost assumptions by PGG restructuring scenario 21

Table 3. Assumptions for mining and investments in the PGG restructuring scenario 22

Table 4. EBIT per tonne of coal by PGG restructuring scenario 23

Table 5. Shifting PGG restructuring costs onto consumers, by restructuring scenario 28

Table 6. Cost assumptions by acquired mines restructuring scenario 32

Table 7. Assumptions for mining and investments by acquired mines restructuring scenario 32

Table 8. EBIT per tonne of coal by acquired mines restructuring scenario 33

Table 9. Shifting acquired mines restructuring costs onto consumers, by restructuring scenario 38

Table 10. Key EU environmental standards for the energy sector and their impact on the Polish

energy sector 39

Table 11. EBIT per tonne of coal at PGG under stagnation of coal prices 42

Table 12. Shifting PGG restructuring costs onto consumers under stagnation of coal prices 45

Table 13. EBIT per tonne of coal at acquired mines under stagnation of coal prices 47

Table 14. Shifting acquired mines restructuring costs onto consumers, by restructuring scenario 48


54

Chart 1. Productivity in underground coal mines in Europe and the United States 17

Chart 2. Average mining depth in underground coal mines 18

Chart 3. Prices of Polish and Australian coal, 2011–2016 19

Chart 4. Hard coal production and consumption in Poland, 1990–2015 19

Chart 5. Assumed improvement in mining productivity by PGG restructuring scenario 20

Chart 6. Employment by PGG restructuring scenario 20

Chart 7. Mining costs and coal sales prices by PGG restructuring scenario 22

Chart 8. EBIT to sales ratio by PGG restructuring scenario 23

Chart 9. Cash flows from the investors’ perspective by PGG restructuring scenario 24

Chart 10. Net present value of the investment in PGG from the investors’ perspective by

restructuring scenario 24

Chart 11. Estimated investment capacity of PGE and Energa in 2016-2036 by PGG restructuring scenario and developments on the energy market 25

Chart 12. Estimated impact of PGG on the investment capacity of PGE and Energa in 2016-2036 by

restructuring scenario and developments on the energy market 26

Chart 13. Present capitalisation of PGE and Energa and net present value of the investment in PGG

by restructuring scenario 27

Chart 14. Estimated impact of PGG on the market capitalisation of PGE and Energa in 2016-2036 by restructuring scenario 27

Chart 15. PGG’s equity in various restructuring scenarios 30

Chart 16. Assumed improvement in mining productivity by acquired mines restructuring scenario 31

Chart 17. Employment by acquired mines restructuring scenario 31

Chart 18. Mining costs and coal sales prices by acquired mines restructuring scenario 33

Chart 19. EBIT to sales ratio by acquired mines restructuring scenario 33

Chart 20. Cash flows from the investors’ perspective by acquired mines restructuring scenario 34

Chart 21. Net present value of the investment in the acquired mines from the investors’

perspective by restructuring scenario 35

Chart 22. Estimated investment capacity of energy companies in 2016-2036 by acquired mines restructuring scenario 36


55

Chart 23. Estimated impact of the acquired mines on the investment capacity of energy

companies in 2016-2036 by coal mining sector restructuring scenario 36

Chart 24. Present capitalisation of energy companies and present value of the investment in acquired mines by coal mining industry restructuring scenario 37

Chart 25. Estimated impact of the acquired mines on the capitalisation of energy companies by

coal mining sector restructuring scenario 37

Chart 26. Investment expenditure in the Polish energy sector by 2030 for various levels of

greenhouse gas reduction, in PLN billion 40

Chart 27. Prices of Australian coal in 1970–2015 and forecast for 2016–2036 (USD per tonne, fixed prices from 2010) 41

Chart 28. EBIT to sales ratio of PGG under stagnation of coal prices 42

Chart 29. Net present value of the investment in PGG from the investors’ perspective under

stagnation of coal prices 43

Chart 30. Estimated impact of PGG on the investment capacity of PGE and Energa in 2016-2036 depending on the developments on the energy market and under stagnation of coal prices 44

Chart 31. Estimated impact of PGG on the market capitalisation of PGE and Energa in 2016-2036 under stagnation of coal prices and in the absence of any major restructuring initiatives 44

Chart 32. “Peak coal” in Western Europe and Poland 46

Chart 33. EBIT to sales ratio of acquired mines under stagnation of coal prices 47

Chart 34. Net present value of the investment in mines from the investors’ perspective under

stagnation of coal prices 48

Chart 35. Estimated impact of acquired mines on the investment capacity of energy companies in

2016-2036 depending on the developments on the energy market and under stagnation of coal

prices 49

Chart 36. Estimated impact of the acquired mines on the capitalisation of energy companies

under stagnation of coal prices 49

Energy, Climate and Environment Programme

Poland, Europe and the world are currently facing unprecedented challenges associated with

the environment and resources. Avoiding dangerous climate change, improving public health and increasing

resource security requires a profound economic transition. Taking advantage of opportunities and avoiding

the associated developmental traps requires in-depth evaluation of the short- and long-term impacts of

environmental protection and natural resource management policies. Under the Energy, Climate and

Environment Programme, we prepare comprehensive sectoral and macroeconomic analyses, focusing on the

broadly defined low-emission economic transition in Poland and globally. We are active in areas such as:

Polish and EU energy and climate policy, domestic resource policy, improving resource efficiency in the

economy, protection of the environment and public health by limiting harmful emissions, sustainable

transport policy. This paper is a part of the Energy and Climate Project.

Energy and Climate Project Manager – Aleksander Śniegocki

978-83-64813-20-7

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