Factors Driving Utilities Stock Performance
The authors are analysts of KB Securities. They can be reached at hyejung.jung@kbfg.com and seongjin.kang@kbfg.com, respectively. — Ed.
I. Domestic Market for Nuclear Power Plants to Shrink
1. Construction to begin downward trajectory in 2024
KEPCO E&C revenue will be largely curtailed
There will be no construction of nuclear power plants in Korea starting in 2024, from which point KEPCO E&C revenue from engineering/construction for such will be largely curtailed. There will be no plants to follow the commencement of operations for the four currently under construction (i.e., Shin-Hanul No. 1-2, Shin-Kori No. 5-6).
Nuclear-free government policy halts domestic order placements
The government’s new energy policy indicates no order placements for nuclear power for the time being. The 8th Power Development Plan envisions a nuclear-free era that involves: (1) the scrapping of any plans to build nuclear power plants, nullifying the 7th plan, which includes the set-up of six new plants (i.e., Shin-Hanul No. 3-4, Chunji No. 1-2 and Daejin No. 1-2); (2) the decommissioning of old plants; and (3) a ban on extensions for period of operation. The 9th plan, which was released in early May, kept the nuclear phase-out policy in place, suggesting a lull in construction for nuclear plants for the time being.
2. Maintenance to increase until 2024
Drop in capacity after 2024 to weigh on maintenance workload
The maintenance workload for nuclear power plants in Korea will begin to decline after 2024. Outdated plants will be suspended in succession following an increase in no. of new plants between 2019 and 2024 (23.3GW→27.3GW; +3.2% CAGR). Maintenance demand should be sustained until 2084 based on plant life spans, but market capacity should descend to 19.4GW in 2034 (2024-34 CAGR of -3.3%) and 8.4GW in 2056 (2024-56 CAGR of -3.6%). We believe the domestic market for nuclear power plant maintenance is stable but holds no growth potential.
3. Decommissioning unable to replace construction and maintenance
Expansion in decommissioning not enough
The market for nuclear reactor decommissioning in Korea will expand, but not enough to replace the markets for construction (KEPCO E&C) and maintenance (KEPCO KPS).
Domestic market for decommissioning still in early stage
The domestic market for decommissioning is still in its early stage. Currently, there are only two reactors (i.e., Kori No. 1, Wolsung No. 1) that have reached the end of their lifespan and shut down. Kori No. 1 is set to be permanently closed and prepped for dismantling. Having no prior experience in decommissioning, Korean companies need to invest more in related technology. According to the Korea Atomic Energy Research Institute, as of 2018, Korean companies possess only 72% of required technology.
Each project for reactor dismantlement to generate KRW54.2bn in revenue per year, below KRW61.6bn coming from design and maintenance
The Ministry of Trade and Energy has set a KRW812.9bn budget for each reactor dismantlement (as of end-2019). Each project will generate KRW54.2bn in revenue per year (assuming each project takes 15 years), below the combined revenue from reactor design (KRW31.4bn) and maintenance (KRW30.2bn). Given that up to 109 companies may participate in various phases, KEPCO KPS and KEPCO E&C’s shares of revenue will be relatively small. Hence, dismantling projects will be nowhere close to adequately replacing nuclear plant construction projects.
II. Overseas Nuclear Power Plant Market Poses Difficulties
1. Demand rapidly growing among emerging countries, but only handful can be penetrated
Demand rapidly growing among emerging countries
Global demand for nuclear power plants has been slowing, but demand is rapidly increasing in emerging countries, forecast to grow from 88GW in 2018 to 232GW in 2040, or 4.5% CAGR vs. global demand at 0.64% CAGR (IEA, World Energy Outlook 2019).
China, India, Russia, Eastern Europe and Middle East
Demand growth has been brisk in China, India, Russia, Eastern Europe and the Middle East. Of planned/proposed nuclear power plants, 52% are in China; 13% in Russia, Poland, the Czech Republic and other Easter European countries; 9% in India; and 7% in Saudi Arabia and other Middle Eastern countries. Growth in China, India and the Middle East should be particularly fast. Total planned capacity stands at 5.4x existing plant capacity (as of end-2019) in China, 6.9x in India and 18.6x in the Middle East.
Middle East: Most promising market for Korea
Among the rapidly growing markets, China and India are looking to develop their own reactors. They have already selected reactors for pending nuclear power plants, leaving little to no room for Korean reactors to move in. For Russia and Eastern Europe, geopolitics and the designs of existing reactors are major entry barriers for Korea. Hence, the Middle East seems to be the most promising.
China & India: Domestic reactors forming mainstream
China and India have both developed their own reactors. With their governments nurturing advances in related technology, it will be difficult for foreign-made reactors to find openings into either market. In China, the most active market player, 69.5% of existing reactors are domestically made (e.g., Hualong-1 and CPR-1000) and 92.4% of planned reactors are Chinese. In India, 59.7% of existing reactors are domestically made (e.g., IPHWR) and 37.8% and 27.0% of planned reactors are Indian and Russian, respectively.
Russia & Eastern Europe: Geopolitical issues
Geopolitical issues have made forays into Russia and Eastern Europe quite challenging. Nuclear reactors are intertwined with politics and diplomacy because they utilize nuclear technology. For instance, Russia and Eastern European countries only employ Russian reactors, whereas 73.2% of reactors in the United Kingdom is British, 11.4% in the United States is American and 15.5% in France is French. The seven reactors in operation in Spain are all American, while the Netherlands’ single reactor is German. For pending nuclear power plants, Russia and Eastern European countries (excl. the Czech Republic and Poland) have chosen Russian while the United Kingdom has chosen British (44%) and French (33%).
Middle East: Most countries yet to decide on reactor and UAE to provide reference for Korean reactors
the Middle East seems to be the most likely export destination for Korean reactors. The region accounts for 7% (33.9GW) of global demand. Major markets include Saudi Arabia (17GW; 16 reactors) and Turkey (13.1GW; 11 reactors). The Middle East has only recently begun to employ nuclear energy, so it does not have any self-developed reactors. On a positive note, planned nuclear power plants have yet to decide on reactors. Of the planned/proposed nuclear plants in the world, 11% have yet to be decided on, of which 37% are in the Middle East. Hence, the region is the most promising market for Korean reactors. The four Korean reactors at UAE’s Barakah nuclear plant will provide some positive reference for Korea-made reactors in the region. Recent deterioration of profitability due to three factors
2. Risk factors: Worsening profitability for construction
Recent deterioration of profitability due to three factors
Profits from construction have recently declined, weighed down by (1) an increase in costs due to toughened safety rules in the wake of the Fukushima nuclear disaster in 2011; (2) additional costs caused by extended construction periods due to issues involving licensing or construction sites; and (3) the weakening price competitiveness of nuclear power against other energy sources in client countries.
Japanese constructors: Factors behind their failure
Evidence of weakening profit margins for construction of nuclear power plants can be found in Japan’s past experience in the United Kingdom and Turkey. In 2013, Japanese constructors made their foray into the global market by winning bids for projects in Moorside/Anglesey, U.K., and Sinop, Turkey. However, following the Fukushima disaster, construction costs rose after stricter safety standards were implemented.
a. Increasing construction costs
With construction costs increasing, it has become difficult to recover investments in nuclear plants after completion. For simple engineering, procurement and construction (EPC) projects, project owners pay construction costs and construction companies build plants. For construction companies in the United Kingdom and Turkey, however, construction costs were paid and revenue from electricity sales after construction were garnered. At the same time, with the price competitiveness of renewable energy strengthened against nuclear energy, fueled by capacity expansion and technological developments. As a result, constructors of nuclear power plants began to worry over a potential decline in electricity sales volume. Japanese constructors proposed a plan to raise electricity prices, but they failed to reach a deal with either the United Kingdom or Turkey.
b. Difficulty in securing additional capital amid concerns over profitability
In addition, concerns over project profit margins rendered additional financing difficult. In the case of Hitachi, it originally planned to finance 67% of construction costs via loans from the U.K. government and 33% via investments in the United Kingdom and Japan. However, the Japanese company failed to find investors amid spiking construction costs. It asked for additional funds to the U.K. government, but with the request was rejected, leading to Hitachi pulling out of the project.
c. Japanese projects suspended following massive losses
As Japanese constructors failed to secure a sufficient profit margin or additional capital for construction, they pulled out of the projects, booking massive losses, such as KRW7tn for Toshiba and KRW3.1tn for Hitachi.
3. Korea’s outlook for nuclear plant orders
Upbeat order outlook for Saudi Arabia and Czech Republic
Among the bids for overseas orders, Korean constructors are well-positioned to win orders in Saudi Arabia (50% chance) and the Czech Republic (20%).
Saudi project (two 1.4G nuclear reactors): preferred bidder to be selected this year
The nuclear plant project in Saudi Arabia (two 1.4GW-capacity nuclear reactors by 2030) boasts the highest progress rate. In March 2019, the Saudi government announced a shortlist of bidders, including the United States (Westinghouse), China (CGN), France (EDF), Russia (Rosatom) and Korea (KEPCO consortium). The preferred bidder will be selected this year. However, the schedule has been delayed, as Saudi Arabia is negotiating with the United States over the approval of uranium enrichment.
Czech project (two 1.2G nuclear reactors): bids to begin in 2021 and contract to be signed in 2024
nuclear plant project in the Czech Republic (two 1.2GW-capacity nuclear reactors), has recently made some headway. The schedule entails bids in 2021, contract signing in 2024 and start of construction in 2029. Currently, the most promising bidders are China (CGN), Russia (Rosatom) and Korea (Korea Hydro & Nuclear Power). Others include France (EDF), a France-Japan consortium (ATMEA) and the United States (Westinghouse).
Saudi bid looks promising; outlook for Czech project upbeat but with limitations
Korea has a good chance of winning the Saudi project given its successful track record in the UAE and the likelihood of building a consortium with the United States. As for the Czech project, Korea is one of most promising candidates alongside China and Russia, but its bid appears limited in view of (1) the six Russian nuclear reactors currently in operation in the Czech Republic and (2) geopolitical factors.
III. Domestic Market for Thermal Power Plants: Coal Fading, LNG Rising
1. Coal-fired power capacity to shrink beginning in 2023
Government policy winding coal down
Domestic coal-fired power capacity should contract after peaking at 40.6GW in 2023. Seven power plants (combined capacity of 7.2GW) are currently under construction. Once the Samcheok plant is completed in 2024, no more coal-based power will be added. According to the 9th Plan, 30 coal-fueled plants are scheduled to be decommissioned (10 under the 8th Plan plus 20 under the 9th Plan), totaling combined capacity of 15.3GW.
2. LNG power plants to takeover
Government policy favors ramp up of LNG
Domestic LNG power capacity should expand from 40.2GW in 2019 to 58.5GW in 2034 (3.0% CAGR). Government policy on reducing the use of coal and nuclear power as energy sources should shrink capacity for both after peaking in 2025, with the void to be filled by LNG power. According to the 9th Plan, among the 30 coal-fired plants set for decommissioning (until 2034), 24 will be replaced with LNG power plants.