Vattenfall AB. Update following confirmation of A3/P-2 ratings. CREDIT OPINION 25 May Update

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1 CREDIT OPINION Vattenfall AB Update following confirmation of A3/P-2 ratings Update Summary Rating Rationale Vattenfall's A3 rating reflects the (1) scale and breadth of Vattenfall's operations and material if declining contribution from generation as a result of lower power prices and expected disposal of German lignite operations; (2) lignite disposal will reduce Vattenfall s political risk and exposure to carbon; (3) solid earnings and growing contributions from lower risk networks, district heating and renewables; and (4) the likelihood that the Swedish nuclear fuel tax could be abolished in the near term supporting Vattenfall s profitability. RATINGS Vattenfall AB Domicile Sweden Long Term Rating A3 Type LT Issuer Rating Outlook Negative Please see the ratings section at the end of this report for more information.the ratings and outlook shown reflect information as of the publication date. Contacts Helen Francis VP-Sr Credit Officer helen.francis@moodys.com Neil Griffiths Lambeth Associate Managing Director neil.griffiths-lambeth@moodys.com These factors are balanced against (5) continuing low power prices in Northern Europe; and (6) the risk that Vattenfall s German nuclear liabilities in relation to interim and final storage will be externalized and payment of a 35% premium will be required by the German government in order to remove the associated liability. Vattenfall s obligations are, however, rather modest in the context of German peers; (7) the company s financial profile is expected to weaken as hedges roll off and be tightly positioned against guidance of FFO/net debt of approaching 20% and RCF/net debt of approaching 15%. Given its 100% ownership by the Government of Sweden, the rating incorporates one notch of uplift from the company's baa1 stand-alone credit quality, or Baseline Credit Assessment (BCA). Exhibit 1 Vattenfall s financial metrics are expected to weaken from 2015 levels Source: Moody's Financial Metrics and Moody's Investors Service estimates

2 Credit Strengths Predominant clean generation energy mix assuming lignite disposal goes ahead Solid earnings contribution from low-risk regulated and contracted businesses Supportive stance of government of Sweden in relation to dividends Credit Challenges Challenging operating environment with low power prices maintaining pressure on earnings Risk that German nuclear liabilities, for interim and final storage, will be externalized with a premium being required to remove the associated liability High level of production taxes Rating Outlook The negative outlook reflects the challenges that should power prices continue to remain low and/or the nuclear fuel tax not be abolished, Vattenfall s financial profile could fall below guidance for the current rating category. Factors that Could Lead to an Upgrade The rating outlook could stabilise over time, if there were a positive outcome on production taxes, Vattenfall continues to make progress on its shift toward more regulated and contracted earnings and the company s financial profile were to stabilise within guidance. Factors that Could Lead to a Downgrade Further downwards pressure on the rating could develop should the financial profile look set to weaken, potentially as a result of failure to amend taxes, power prices were to fall significantly lower or required nuclear investments placed an additional financial burden on the company, without offsetting measures. Key Indicators Exhibit 2 Vattenfall AB [1] [1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. Source: Moody's Financial Metrics Detailed Rating Considerations Operating conditions remain challenging for generation Operating conditions remain very challenging in Northern Europe. On the back of low commodity prices, in particular coal and carbon, over the last 12 months electricity prices in Germany and the Nordic area have fallen by over 20% to levels of around EUR midtwenties/ MWh and around EUR low twenties / MWh respectively. We expect prices to remain low and volatile. Vattenfall has a diversified generation portfolio including nuclear and hydro power in the Nordic region, coal and gas in Germany and the Netherlands and wind power in Germany, the Netherlands, UK and Denmark. Assuming Vattenfall s agreed sale of its German lignite operations to EPH goes ahead, its portfolio will be principally hydro and nuclear, a mainly fixed cost fleet. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

3 Assuming this transaction goes ahead, SEK18 billion of liabilities and SEK 15 billion of cash will be transferred to the buyer. According to Vattenfall, it also maintains SEK9 billion of in-the-money hedges in relation to these operations, which could benefit cash flow as they roll off or are potentially sold. The sale is subject to Swedish government approval. Vattenfall remains challenged by high costs on its nuclear plants due to nuclear capacity taxes which increased in 2015 to around EUR7/MWh, making nuclear production unprofitable at current levels on an all-in basis. These taxes are currently the subject of a review by the energy commission in Sweden and we believe there is a good chance that these will be abolished, which would have a significant positive impact on Vattenfall s credit metrics. Abolition would also justify investments in Vattenfall s six nuclear reactors, built in the 1980s, required in order to both extend their life and improve efficiency, which would in turn lead to lower costs. A reduction in hydro taxes, which remain high in the context of current power prices, would also have a beneficial impact on credit metrics. Removal of these taxes should also mitigate the impact of lower prices as hedges roll off. In Sweden, the challenging power price environment and taxes on nuclear capacity led to Vattenfall's decision in 2015 to push through the early shutdown of two (Ringhals 1 and 2) of its seven nuclear reactors over Whilst commodities remain the key driver, increasing renewables in the Nordic area and the new nuclear plant OKO 3 in Finland, due to open in 2018/19 will maintain downwards pressure on prices. However, new interconnectors and the closure of some nuclear capacity at Ringhals and Oskarshamn towards the end of the decade may mitigate the effect. In the context of more volatile generation conditions, Vattenfall's hydro assets are likely to become more valuable. Contributions from lower risk businesses should grow as conventional generation falls Vattenfall maintains strong market positions in regulated networks and district heating. It is the second-largest network operator in the Nordic region, owns and operates the electricity distribution grid in Berlin and has the largest district heating business in Germany. District heating is not a regulated business, but it has quasi-monopoly characteristics and generates generally stable cash flow, given the high barriers to entry and long-term heat contracts. In addition, the company is directing its growth capex towards onshore and offshore wind, which is supported by contracts or incentives. Nonetheless, there are a number of execution risks as Vattenfall makes this transition, as construction risk remains high on offshore wind until projects. Additionally Vattenfall has a solid base of electricity retail customers which provides a moderate natural hedge to cash flows. We estimate these regulated and contracted businesses to contribute well over 50% of EBITDA over the next few years. Funding of German nuclear obligations could crystallise Vattenfall has rather moderate exposure to German nuclear liabilities compared to German peers. The rating takes into account the recent unanimous recommendation by the German government-appointed nuclear commission that (1) the liabilities of the German nuclear generators for interim and final storage should be externalised into a separate public fund backed by liquid financial assets from the companies; and (2) a premium, of around 35%, should be paid by 2022 in order to release the generators from these obligations. In our view, there is a good likelihood that, while there may be further negotiations on the final calculations of the underlying liabilities, a solution will be found and passed into law. Should an agreement not be reached and passed into law this year, we believe the issue will remain a significant overhang for the companies. In mitigation, once these long dated storage liabilities plus the premium are fully met, the companies would be released from their associated obligations, thereby reducing political, business and financial risk. Financial strategy Vattenfall has maintained a focus on defending its financial flexibility through divestments, capex and cost reductions. Vattenfall has a 2 year investment plan in place; a total of SEK47 billion is set aside for 2016/17. 36% of total investment is dedicated to growth capex out of which 93% will be focused on wind. The rating also factors in the shift in business mix towards regulated and contracted earnings as a result of the lignite disposal, lower prices and the company s emphasis on growth capex in renewables, as well as networks and district heating. In recognition of this shift, guideline metrics are set at FFO/net debt of approaching 20% and RCF/net debt approaching 15% for the current rating category. These guidelines would be consistent with a risk profile where the contribution from merchant generation remains around 30% of EBITDA. Should this business activity represent a higher contribution to earnings, for example were power prices to rise, then the guidance would be higher, reflecting the more volatile profile of these cash flows. Vattenfall may also decide to sell down stakes in 3

4 wind farms. The rating will factor the benefits of diversification and risk sharing, however, such a strategy could increase the degree of cash leakage to minority shareholders and ratio guidance could tighten accordingly. Ratings uplift given ownership by the Government of Sweden Vattenfall's A3 rating incorporates a rating uplift of one notch from its BCA of baa1, reflecting the utility's 100% ownership by the Government of Sweden and the strategic importance of the company within Sweden, at the same time acknowledging the state's determinedly non-interventionist stance. We believe that the authorities would hesitate to intervene (such as through a direct capital injection) except in the most extreme circumstances, i.e., where there is a threat to key strategic Swedish assets such as key nuclear and hydrological generating assets, and its network infrastructure. The State has nonetheless been supportive towards Vattenfall with regard to its dividend policy. It also supports Vattenfall's low CO2 policy, which is in keeping with the proposed disposal of its lignite assets. For a number of years, Vattenfall's financial policy has been balanced between shareholder and bondholder interests. Vattenfall set out revised financial targets, agreed with its shareholder, in November 2012, including FFO/adjusted net debt of 22%-30%; net debt/equity of 50%-90%; Return on Capital Employed of more than 9% and an unchanged payout ratio of between 40% and 60%. However, given a negative result after tax, mainly due to impairment losses, the owner did not extract any dividends from Vattenfall in the past few years and is not expected to do so on 2016 results given an expected impairment on the lignite transaction. Vattenfall's Board of Directors proposes, in accordance with Vattenfall's dividend policy, that no dividend be paid on 2015 results. This follows a net loss after tax of SEK19.8 billion, following impairments taken during the course of the year. Liquidity Analysis As at end of March 2016, Vattenfall has a strong liquidity position which is supported by (1) cash and cash equivalents of SEK15.3 billion and (2) short term investments of SEK22.2 billion. Excluding unavailable liquidity or restricted funds (SEK7.3 billion) this leaves available liquidity of SEK30.1 billion. This is a significant reduction on the total available liquidity of SEK37.4 billion as at end of December 2015 and is due to the completion of the lignite transaction. Vattenfall has a committed Revolving Credit Facility of EUR2 billion (SEK18.5 billion), all of which is undrawn. The RCF expires in December 2020, with a one-year extension. The company tends to fund its short-term requirements through its two commercial paper (CP) programmes, a EUR2 billion (SEK18.5 billion) euro CP programme and a domestic CP programme of SEK15 billion (EUR1.6 billion). Vattenfall can access the capital markets for longer term funding using its EUR15 billion (SEK139 billion) euro medium-term note (MTN) programme. Corporate Profile Vattenfall AB, a 100% Swedish state-owned company, is the largest utility in the Nordic sector, as well as the third-largest electricity producer in Germany. Vattenfall owns and operates hydro and nuclear power plants in the Nordic region, and coal and gas plants in continental Europe. It is also increasing its presence in wind power, biomass and waste. It is the second-largest network operator in the Nordic region, owns and operates the electricity distribution grid in Berlin and has the largest district heating business in Germany. As of 31 December 2015, the company had a retail base of 6.2 million electricity customers and 2.1 million gas customers. Vattenfall's output in 2015 was 173 terawatt hours (TWh), which makes it one of the larger generators in Europe. Its revenues for the full year to December 2015 were SEK165billion (EUR17.5 billion). As at 31 December 2015, Vattenfall had assets of SEK462 billion (EUR52 billion). 4

5 Rating Methodology and Scorecard Factors The methodology used in these ratings was Unregulated Utilities and Power Companies published in October Exhibit 3 Rating Factors Vattenfall AB [1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. [2] As of 31/12/2015; Source: Moody's Financial Metrics [3] This represents Moody's forward view, not the view of the issuer, and unless otherwise noted in the text does not incorporate significant acquisitions or divestitures Ratings Exhibit 4 Category VATTENFALL AB Outlook Issuer Rating Senior Unsecured Subordinate MTN Commercial Paper Moody's Rating Negative A3 A3 (P)Baa1 P-2 Source: Moody's Investors Service 5

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