Business Vulnerability to Changes in Energy Prices in the Baltics. KPMG in the Baltics

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1 Business Vulnerability to Changes in Energy Prices in the Baltics KPMG in the Baltics

2 The results and finding presented in this presentation are based on data readily available in open sources like EUROSTAT, local Baltic countries statistical offices data, European commission Directorate General for Transport and Energy, local Baltic heat and power associations, etc. In performing this study, we aimed to keep the results easily understandable to the general public, as well as to decision makers and investors alike. For this reason, calculations were done in a straight forward manner, not always following accounting standards for recognition of costs, tax and other profit and loss items. The sensitivity model results are made for demonstration purpose only; given the fact that they are based only on the financial results of the surveyed economic sectors for the year 2010 (for reasons of data availability in all three Baltic states for the period studied), the results should be viewed as indicative and relevant to the specific point in time they refer to.

3 Business Vulnerability to Changes in Energy Prices in the Baltics 3 Table of contents Preface 4 The cause for energy vulnerability 6 Reducing energy vulnerability is driven by EU RES targets for the Baltics 8 Increase in the share of RES in the final energy demand is key 9 to reducing vulnerability to the increase in energy prices Reducing vulnerability to fossil commodity prices by developing 10 renewable energy Importance of CO 2 allowances and tax policies for curbing 11 energy price increase Reduce energy intensity to reduce sensitivity to escalation of 12 energy prices About the study Overview of business sectors 15 Overview of energy prices 17 Energy price change scenarios 20 Conclusions 22

4 4 Business Vulnerability to Changes in Energy Prices in the Baltics Preface While Latvia, Lithuania and Estonia became independent states 20 years ago, Russian supplies of energy commodities to the Baltics are still significant: Russia supplies the Baltics with the major portion of their energy needs in electricity, coal, natural gas, oil and oil products. Moreover, the Baltic states have few connections to the EU energy commodities markets, having no gas pipeline connections, and limited electrical connection capacity to the UCTE and NORDEL electric systems. This situation gave grounds for the EU and local Baltic governments to consider the Baltic region as an Energy Iceland, striving to design policies to remedy this state of affairs by introducing the Baltic Energy Market Interconnection Plan (BEMIP). On the basis of this major policy measure, energy infrastructure projects are being planned and implemented in the region, to develop alternative routes of delivering energy to the Baltics. These projects include electric interconnections such as ESTlink 2, SwedLit, and LitPolLink, as well as gas interconnections between Poland and Lithuania, an LNG terminal in Lithuania and possibly other Baltic states, as well as the development of gas and electricity transmission infrastructure across the Baltics. The crown jewel among these large energy infrastructure projects is the Visaginas nuclear power plant project in Lithuania. Further to these measures, important policy changes are in place to facilitate opening of the electricity market to wholesale trade, and separation of energy generation from supply and trade functions, all in an effort to implement the EU 3rd Regulatory Package requirements within the framework of local legislation. Typically, the energy dependence of any country is determined by the share of energy imports in the total energy consumed by its economy. In 2010, the Baltic countries produced 5.5 million tonnes of oil equivalents, and imported 11.4 million tons of oil equivalents importing twice as much as that produced. Large import dependence is apparent in Lithuania, which, after the closure of the Ignalina Nuclear power plant, required that its power balance be supplemented by direct import of electricity and gas for power generation; however, the results of our survey indicate that Latvia is the Baltic leader for energy consumption when taking total energy use by the economy into account. The smallest deficit was registered in Estonia, which continues developing and investing into oil shale based power generation, as well as in renewable energy projects, while exporting excess electricity produced to the other Baltic countries and to the Nordpool trade areas. Energy supply import dependence, in and of itself, is not a major hindrance to proper local energy market operation or to energy security. In 2010, the Spanish dependence on imported energy was 81%, in Belgium 78%, Austria 73%, and in Germany 61%. Quite a different view on energy security and on the vulnerability of the leading Baltic economic sectors to energy commodity price escalation is revealed when looking at the energy use and energy efficiency of each of the Baltic economies. The Baltic countries spent 9.1% of their gross domestic product (GDP) in 2000 on fuel imports; by 2010 they had spent 13.0% of their combined GDP. This is a much higher value than that of other EU countries. The Baltic countries will be spending larger proportions of their GDP on energy imports by 2020, which could render their economies inefficient and unsustainable. The reason for the high costs and high level of dependence on energy imports is the extremely low energy efficiency of the Baltic economies. This can be measured by indicators such as the GDP energy efficiency (kilograms of oil equivalent, spent on producing every EUR 1,000 of GDP). Assuming that the European average GDP energy efficiency value in 2009 represents 100%, in Estonia and Latvia these values were approximately 430% of that base value, while in Lithuania it was 315%. After the closing of the Ignalina power plant in 2010, the GDP energy efficiency of Lithuania was reduced to a similar level of its other Baltic peers. Finland, which is located north of Estonia, and has similar heating needs, bears GDP energy efficiency that is only 57% higher than the EU-27 average. The GDP energy efficiency of industry and production in the Baltic countries is gradually increasing. However, at the rate of current improvements, it will take the Baltic states a very long time to arrive at EU average levels, emphasising the need to increase the level of investments into energy and energy efficiency projects in the Baltic region. Thus, to overcome the dependence on energy imports, the Baltic countries should strive to decrease the use of fossil

5 Business Vulnerability to Changes in Energy Prices in the Baltics 5 fuels by replacing them with local energy sources as much as possible, while at the same time striving to increase the energy efficiency of the region s leading economic sectors. This should be achieved by improving the insulation of industrial buildings and homes, reducing losses during transmission and distribution of heat and electricity, introduction of Smart Grid solutions and metering to manage energy demand much more efficiently, introducing energy efficient production processes in energy-intensive industry, reducing demand at source by using more energy efficient appliances and equipment, making investments in modern high efficiency power and heat generation facilities fuelled by renewable fuels as well as in the distribution and accumulation of energy. The above measures should be supported by mandatory standards, regulating energy consumption (construction and energy labelling), as well as by developing proper fiscal measures and energy sector economic regulation, to facilitate their proper implementation. Without significant reduction in energy consumption, the replacement of the Russian fuelled energy sector in the Baltics by other investors, might only prove to be a simple replacement of asset owners, rather than a measure bringing a long lasting reduction of energy costs to the Baltic economies. Careful analysis should be done on the feasibility of primary energy supply and distribution across the Baltics from new sources, as the energy commodity markets have proven to be historically very volatile, making forecasting energy commodity prices a specialised task requiring a global perspective and true knowledge of energy commodity markets logistics and contracting terms. Such analysis is imperative if the Baltics are to have feasible infrastructure projects implemented and financed. One of the ways many countries have been considering approaching this topic is by designing a wide range of financial instruments, tax policies and subsidy schemes, which do not narrowly rely only on direct subsidy mechanisms such as Feed-in Tariffs for renewable energy support. These states develop leveraged funds, revolving funds, voluntary green certificate markets and other economic measures in order to provide a true economic framework for investments in the energy sector, which national budgets can rely on and investors are able to use efficiently. It should be emphasised that all relevant energy generation sources and technologies are normally being considered and implemented within a country s energy mix. This is certainly true for the nuclear project plans in the Baltics, where a large gap in power generation capacity requires the construction of a large base-load generation facility able to produce cost effective electricity. The construction of such a power plant is indeed a colossal undertaking for Lithuania and for the region, posing many risks to national budgets possible due to cost and schedule overruns. The inclusion of proper and objective project management practices is of key importance for the successful implementation of such projects and for finally achieving the electricity cost objectives originally planned for. In Latvia, the Daugava river poses significant renewable and low cost energy resource. While the large hydro power plants in Latvia have been successfully operating for years, exploring the option to expand hydro power capacity as well as a pumped hydro power plant is desirable. It is particularly important in view of Latvia s partial reliance on large gas CCGT power plants, which are fairly expensive to run and which need to be hedged by complementary hydro power (or renewable) generation capacity in Latvenergo s portfolio. Fiscal austerity measures in the Baltic region, triggered by recent economic downturn, and the heightened sensitivity of the Baltic economies due to their relatively small size, mean that careful consideration should be given to the design of the energy sector economic regulation and renewable energy support schemes in order to ensure that the interests of both the investor and the end energy consumer are being considered.

6 6 Business Vulnerability to Changes in Energy Prices in the Baltics The cause for energy vulnerability Energy resources in Baltics: three distinct modes of operation Electricity generation mix and fuel source Gas 4% Wind 1% Other 4% Oil shale 91% Imports 30% Gas 20% Hydro 3% Other 3% Other 3% Hydro 47% Comments: The origin of dominant primary and electric energy sources: Estonia local, Latvia local (hydro), imported electric energy and natural gas, Lithuania imported natural gas and electricity; Total annual consumption of electric energy: Estonia 7 TWh/year, Latvia 6 TWh/year, Lithuania 12 TWh/year, total about 25 TWh/year; Shutdown of amortised power plants: Lithuania decommissioned Ignalina nuclear plant in 2009, Estonia to mothball some of oil shale power plants capacity by 2016; A gap between production and consumption capacities in the Baltics is to be expected. (See page 7 for details); Additionally, ~1,500 MW capacity will be based on natural gas imported from Russia, which might pose an upwards price pressure; Although new plants are planned to be developed, these will require large investments and will probably not be completed before ~2020. Natural gas 35% Imports 59% Note: Electricity generation split for Lithuania after Ignalina NPP decommission is estimated based on experts opinion

7 Business Vulnerability to Changes in Energy Prices in the Baltics 7 Projected demand and electricity generation capacities 9,000 Shutdown of Ignalina NPP (Lithuania) 8,000 Baltic agregate Installed Capacity MW 7,000 6,000 5,000 4,000 3,000 Shutdown of old energy blocks in Narva power plants (Estonia) Gap to be filled 2,000 1,000 0 Installed capacity Peak demand Note: Source: Generating capacities to be constructed in the future are not taken into account Elering and ENTSO-E report on system adequacy forecast In Latvia, electricity is generated mostly by the three Daugava hydro power plants. After the decommissioning of the Ignalina Nuclear power plant, Lithuania relies heavily on local gas power generation and electricity import. The power system of Estonia has at present 2,477 MW installed capacity. AS Narva Elektrijaamad, oil shale Power Plant, generates approximately 90% of total power and has 2,000 MW installed, of which approximately 1,600 MW do not meet the requirements of the EU directive on large combustion plants. To fulfill environmental requirements, it was decided to install SO2 filters in the four existing oil shale burning units, having a total net capacity of 644 MW. This installation is expected to be completed by The remaining 6 power units of the Narva PP are expected to be mothballed following 2016.

8 8 Business Vulnerability to Changes in Energy Prices in the Baltics Reducing energy vulnerability is driven by EU RES targets for the Baltics Final energy consumption and RES share GWh 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, % 17.5% 40.0% 29.9% 23.0% 15.6% Estonia Latvia Lithuania Final energy consumption 2008, GWh Final energy consumption 2020, GWh RES in Final energy consumption 2008, % RES in Final energy consumption 2020, % 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Source: Leading RES project developers; 4Energy According to an indicative scenario provided by leading market participants, approximately 3,600 MW of wind energy capacity and 650 MWel of biomass/biogas energy capacity should be additionally installed in the Baltics in order to meet EU 2020 targets set for the region. Most of the growth potential for renewable energy in the Baltics lies in the development of wind energy in Estonia, Latvia and Lithuania and biomass CHPs in all three Baltic countries. RES share in final energy consumption targets for Estonia Latvia Lithuania Final energy consumption, GWh RES in final energy consumption, % 40,612 59,347 69,034 25% 40% 23% New installed capacities* to fulfill EU 2020 targets (Prevailing market participants Scenario). Biomass new installed capacity*,mwel Biomass electricity from CHP 2020, GWh 500 1,350 1,000 Biomass heat from CHP 2020, GWh 500 1,350 1,000 Wind new installed capacity*, MW 783 1, Wind total installed capacity 2020, MW 860 1,892 1,051 Wind electricity 2020, GWh 1,920 4,898 2,621 Biogas new installed capacity*, Mwel Biogas energy 2020, GWh Hydro new installed capacity*, MW 0 2,5 10 Hydro electricity 2020, GWh Biofuels increase in consumption 2020*, GWh 1,130 1,687 1,787 * New compared to 2008 Source: Leading RES project developers; 4Energy Compared to the other Baltic states, the Latvian National Renewable Energy Strategy envisages 236 MW of onshore and 180 MW of offshore wind installed capacity by With only 31 MW of current installed capacity and regulatory uncertainty regarding the support mechanism to be provided by Latvia, this Baltic state does not seem to be on track to meet its EU 2020 targets. According to estimates, Latvia needs over 1,000 MW of installed wind energy capacity in order to achieve its 2020 goals. RES energy, GWh Growth in RES compared to 2008, GWh 10,153 23,739 15,878 4,209 9,760 6,871 How to attract investment into the renewable sector of the Baltics (and especially Latvia) is a key question, if decoupling of local economies from fossil fuel-based energy consumption and its price escalation are to be achieved. Source: Leading RES project developers; 4Energy

9 Increase in the share of RES in the final energy demand is key to reducing vulnerability to the increase in energy prices Business Vulnerability to Changes in Energy Prices in the Baltics 9 Final consumption of renewable energy 1,200 1,000 Final energy consumption in the Baltics 6,000 5,000 ktoe Estonia Latvia Lithuania ktoe 4,000 3,000 2,000 1, Estonia Latvia Lithuania Wind 0% Latvia Lithuania Estonia Biofuels 1% Hydro 21% Biomass 78% Wind 2% Hydro 5% Biomass 85% Biofuels 8% Wind 3% Hydro 1% Biofuels 0% Biomass 96% Reduction of dependence on fossil fuel and electricity imports from Russia will increase security of energy supply and assist in decoupling the local Baltic economies from dependency on fossil fuel price increases. Though the Baltic countries are advancing in developing renewable energy sources in the region, the relatively high proportion of biomass-generated energy in final energy consumption is a sign for Baltic policy makers to start considering how other renewable energy sources could be promoted as well. Wind, hydro and other local energy sources are important renewable energy sources in need of promotion, especially in view of their well-established lending environment. Providing a balanced renewable energy mix in the local energy production sector of each of the Baltic countries is important in view of the need to ensure that prices of primary renewable energy fuel sources (biomass, peat) are kept competitive in the long run. Although the share of renewable energy in end consumption in Latvia is the highest in the region, end energy consumers do not enjoy this benefit via decreased energy bills. During , the sharpest increase in heat prices occurred in Lithuania (47%), followed by Latvia (43%) and Estonia (39%). During the same period, electricity prices showed the sharpest increase in Latvia (43%), followed by Lithuania (38%) and Estonia (25%). This can be explained by the fact that the mandatory charge for RES-E and efficient co-generation in Baltic countries electricity charges is among the highest in Europe. In Latvia, real renewable fuel-based investments represent only approximately 4% of total new power and heat generation investment in the country, coupled with the fact that this tariff component is mainly intended to support large gas-fuelled CHP projects in Latvia; thus, it seems that local policies currently do not support delivery of a renewable energy price benefit to end consumers. The situation in Lithuania is in many respects similar to that in Latvia; however, due to the much lower share of renewable energy in end energy consumption, it is less profound.

10 10 Business Vulnerability to Changes in Energy Prices in the Baltics Reducing vulnerability to fossil commodity prices by developing renewable energy Example: Hydro impact on electricity spot prce 120 TWh 100 Source: Week in Nord Pool Spot Hydro reservoir energy content Example: Wood fuel price in Estonia (EUR/m 3 ) NordPool spot electricity price EUR/MWh EE price If the Baltics are to achieve energy independence and the curbing of sharp energy price escalation in the future, it is imperative to develop indigenous fuel sources (peat, biomass, hydro, solar, wind, geothermal, marine, heat pumps) for generating heat and power alike. As can be seen in the example above, when hydro reservoir energy content is increased (making it more readily available on the electricity spot market), the much lower level cost of generating electricity by using this energy source and the relative dominance of it on the electricity spot market at a certain point of time, causes electricity spot prices to drop. It should be the vested interest of the Baltic countries to develop RES energy, in order to decouple their economies from fossil fuel price influences as much as possible. It is a challenging task, as a delicate balance needs to be struck on how to accomplish this and who will carry the capital investment costs of this enormous effort. EUR/m Estonia Latvia Source: Estonian Statistical office, Latvian Statistical office, Data for Lithuania was not available. Developing a sustainable forestry industry, in order to ensure that demand is not outstripping supply and causing a sharp increase of the biomass fuel price is another challenge for the Baltic countries. As can be seen from the example above, Estonian wood fuel prices sharply increased during , by approximately 40% followed by a similar trend in Latvia (approximately 33% during the same period). In order to develop a sustainable biomass-based co-generation (CHP) sector, it is imperative to ensure long term sustainability and a fuel price which is representative of supply and demand, hence, the development of a biomass spot market in the Baltics seems to be an inevitable measure policy makers might be inclined to consider.

11 Business Vulnerability to Changes in Energy Prices in the Baltics 11 Importance of CO 2 allowances and tax policies for curbing energy price increase While increasing renewable energy and the energy efficiency of the three Baltic economies might seem to be capital intensive and an expensive endeavour, the current surplus of AAU allowances, especially in Latvia, if planned and coordinated on national and Baltic levels in an appropriate manner, might be used to finance renewable and energy efficiency projects, while avoiding passing the full investment costs to end energy consumers. As an example, for the second emission trading period in Latvia, an emission allowance surplus of approximately 40 million AAUs exists, intended for sale. In 2008 and 2009, Latvia sold 15.5 million AAUs. At a current cost of approximately EUR 3.5 /tonne CO 2 for AAU (Point Carbon recent estimates), the possible capital raising potential is estimated to be approximately EUR 86 million. This capital could be used to finance green energy investments if used correctly, and if proper financial instruments are developed to leverage the use of these funds. Further to this, according to local legislation, revenue from emission trading is added to the state budget and must be spent directly on green investments. Considering this legal requirement and coupled with proper economic planning and regulatory measures, Latvia could boost renewable energy and energy efficiency investments leading to vastly improved economic competitiveness. The benefits outlined above have mostly been transferred to the energy efficiency investment programmes in all three Baltic countries. While energy efficiency is obviously a major bottle neck, imposing considerable strain on GDP growth in the region, the consolidation of fiscal and economic planning efforts in order to allow reaping the benefits of CO 2 allowance trading in all three Baltic states should be considered as a welcomed step toward alleviating sharp fossil fuel-based energy price increases which have been experienced by all three Baltic economies. The Baltic economies face difficult choices when planning proper use of their CO 2 allowances. A balance needs to be struck between the energy and industrial sectors regarding the allocation of emission allowances. If local governments decide to increase exports, the industrial sector should be favoured. If, on the other hand, allocations are made mainly to the energy sector (which is the current practice across the Baltics), it could assist in decreasing heat and power tariffs to end consumers, assuming the full benefit is transferred to end consumers. The Baltic countries should also consider developing a differentiated tax system, such that would send clear signals to investors and energy consumers alike. For example: Lowering VAT on the use of local fuels (in order to generate added value locally within local energy production instead of exporting the fuels to foreign markets); Providing tax incentives to end consumers (industrial or private), if they invest in renewable power or heat generation; Providing differentiated excise tax treatment for car fuels (with a preference to biofuels, natural gas fuels). National energy tax policy should be planned carefully in order to avoid increasing the overall tax burden.

12 12 Business Vulnerability to Changes in Energy Prices in the Baltics Reduce energy intensity to reduce sensitivity to escalation of energy prices Energy intensity of the economy: Gross inland energy consumption per amount GDP produced GJ/1,000 EUR Estonia Latvia Lithuania Source: Statistical offices of Latvia, Estonia, Lithuania and Eurostat Estonia is one of the most energy intensive countries in the EU and among the Baltic countries. Despite this fact it has proven to be a Baltic leader in terms of its economic efficiency and the resilience of the leading business sectors in the country to react to the increase in energy commodity prices. This fact may be partially explained by the primary fuel mix in Estonia, which, unlike in the other Baltic countries, is primarily reliant on oil shale. Leading economic sectors in Estonia seem to have adapted fairly well to the pressing need to increase efficiencies by performing timely investments into improving the efficiency of production processes, streamlined business processes and reduced redundancies. The relatively prudent economic policy of the Estonian state seems to have positioned almost all of the surveyed economic sectors in Estonia in a leading position among the three Baltic countries. It is estimated that when energy efficiency measures and demand-side management measures are fully implemented in Estonia, within the next 5-10 years time, the energy intensity of its economy will become competitive not only at the Baltics level but on a European one, and further contributing to reducing the vulnerability of key economic sectors in the country to increases in energy prices. The highly competitive situation among the three Baltic countries places additional challenges on decision makers as they strive to optimise economic planning measures for the energy sector in each country, in an attempt to find the correct power and heat generation mix, energy efficiency and demand side management as well as the proper use of transportation fuel.

13 About the study... Objectives, methods, business sectors and energy sources reviewed Business Vulnerability to Changes in Energy Prices in the Baltics 13 Electricity Energy resources Heat Objectives: Establish the impact of energy source prices on the cost base of selected business sectors in each Baltic country, attempting to identify the most vulnerable business sector to changes in the cost of energy, while providing a comparison of this effect for all three Baltic countries. Agriculture, Forestry and Fishing Methodology: Business sectors which have significant impact on GDP in all three Baltic states were chosen for the comparative study; Primary Fuel Energy sources: Primary fuel sources looked into were: natural gas, crude oil, coal. Secondary energy sources reviewed were heat, as supplied by local district heating companies, and electricity as supplied by national and local wholesale and retail traders. Industry Construction Trade and Services Transportation Business sector grouping was performed following the methodology used by the statistical offices of each of the Baltic states (dictated by using EUROSTAT methodology); The study was conducted by modelling three different scenarios for escalation of energy resource prices and their effect on the cost base of selected business sectors, ceteris paribus; All data used in this study is from publicly available sources, such as the statistical offices of all three Baltic states, Eurostat, Public Utility Commissions, etc.; Operating costs are not separated from other costs.

14 14 Business Vulnerability to Changes in Energy Prices in the Baltics Description of business sectors reviewed in this study Agriculture, Forestry and Fishing Crop farming and animal farming; Hunting and related service activities; Forestry and logging; Fishing and agriculture. Industry Wood manufacturing wood, wood products, paper, printing; Chemical manufacturing; Pharmaceutical products; Rubber and non-metallic mineral products; Food manufacturing; Textile production; other manufacturing activities. Construction Construction of buildings; Civil engineering; Specialized construction activities. Trade and Services Retail trade; Wholesale trade; Real estate; Accommodation; Telecommunications; Information services; Water and Sewage; Other services. Transportation Land transportation; Other transportation including warehousing operations. Source: Lithuanian, Latvian and Estonian Statistical offices

15 Overview of business sectors Cost and revenue dynamics of selected business sectors in the Baltics Business Vulnerability to Changes in Energy Prices in the Baltics 15 Dynamics of revenue and costs of selected sectors in Baltics % Change 8% 60% 40% 19% 23% 23% 23% 19% 20% 17% 22% 23% 23% 17% 17% 13% 9% 5% 0% -1% -6% 11% 0% 7% 8% -2% -24% -23% -27% -20% -23% -19% -40% -22% -60% EE LV LT EE LV LT EE LV LT EE LV LT EE LV LT In 2006 to 2008 the revenue of surveyed business sectors in the Baltics had increased: 9 to 23%/year in Lithuania; 5 to 19% in Estonia; 23% to -6% in Latvia, a sharp drop. In 2009, revenue plummeted: more than EUR 15 billion in Lithuania; EUR 10.8 billion in Estonia; more than EUR 10 billion in Latvia. In 2010, revenue recovered: 7% in Lithuania; 8% in Estonia; 8% in Latvia. Source: Lithuanian, Latvian and Estonian Statistical offices EE LV LT Revenue dynamics Net profit change of business sectors in Baltics Billion EUR EE LV LT Cost dynamics EE LV LT EE LV LT EE LV LT EE LV LT EE LV LT In the average net profit margin of the surveyed sectors was: 3.2% in Lithuania; 5.6% in Estonia; and 1.6% in Latvia; net profit fluctuations year on year, demonstrating volatility and hence the vulnerability of the Baltic economies, spearheaded by Latvia. Losses in 2009 amounted to -EUR 1.6 billion in Lithuania, -EUR 1.12 billion in Latvia; +EUR 0.48 billion in Estonia (profit) Source: Lithuanian, Latvian and Estonian Statistical offices

16 16 Business Vulnerability to Changes in Energy Prices in the Baltics Country Net profit margin Average EE 10% 9% 3% 1% 5% 5,6% LV 5% 5% 1% -3% 0% 1,6% LT 5% 9% 3% -4% 3% 3,2% Baltic economies began recovering during 2010, while Latvia was still lagging behind. Effect of energy resources costs on profitability of business sectors Agriculture, fishing and forestry Agriculture, Fishing and forestry Trade and Services Construction Industry Transportation Transportation Trade and services Source: LT LV EE LT LV EE LT LV EE LT LV EE LT LV EE Sector Industry Construction Energy resources consumption structure by sector (2010) 31% 28% EE LV LT EE LV LT EE LV LT EE LV LT EE LV LT 34% 37% 54% 72% 70% 76% 87% 84% 90% 90% 92% 91% 99% 51% 54% 50% 47% 43% 17% 25% 18% 11% 15% 21% 9% 8% 16% 16% 11% 14% 6% 5% 6% 2% 1% 3% 1% 2% 2% 1% 6% 3% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Fuel Electricity Heat Net profit margin ( average) 8.6% 13.6% 5.4% 4.4% 2.7% 2.1% 6.2% 1.3% 3.8% 6.0% 1.3% 3.1% 4.9% -1.1% 1.6% Lithuanian, Latvian and Estonian Statistical offices Energy resources as a percentage of total costs ( average) 8.3% 13.5% 6.9% 10.2% 30.7% 10.6% 1.0% 3.0% 1.6% 5.2% 5.1% 5.0% 1.8% 1.1% 2.9% The least vulnerable sector to primary energy price fluctuations in all the Baltic states is the trade and services sector; it also features the second highest net profit margin, while energy costs make up a relatively small portion of total costs. The transport sector in all three Baltic states is the most vulnerable to fluctuations in energy prices; energy is the largest cost contributor in this sector s cost base, while profit margin is one of the lowest among all sectors reviewed. The industrial sector in all Baltic states is significantly influenced by energy prices, while Estonian energy cost content in total costs is similar to other Baltic states, it features the highest profit margins. Agriculture, Fishing and Forestry shows a relatively large component of energy costs in its cost base in all Baltic states, while Latvia is leading the trend in costs as well as profit margins in this sector. The expenditure of business sectors of the Baltic states on energy resources amounted to EUR 1.4 billion in Lithuania, EUR 2 billion in Latvia and EUR 1.5 billion in Estonia, of which: Lithuania: 58% or EUR 0.8 billion on fuel, 33% or EUR 0.5 billion on electricity, 9% or EUR 0.15 billion on heat energy; Latvia: 76% or EUR 1.5 billion on fuel, 19% or EUR 0.37 billion on electricity, 5% or EUR 0.11 billion on heat energy; Estonia: 72% or EUR 1.1billion on fuel, 20% or EUR 0.31 billion on electricity, 8% or EUR 0.13 billion on heat energy.

17 Overview of energy prices KPMG Energy Survey 2011 Business Vulnerability to Changes in Energy Prices in the Baltics 17 Primary fuel price will be on the rise... World fuel price index (2005=100) Crude oil Gamtinės dujos Natural gas Akmens anglis Coal Forecast Findings of the KPMG Energy Survey 2011 : 50% of surveyed executives of largest global energy companies think crude oil price will stay as high as USD a barrel; As much as 40% of respondents claim that the increasing price of energy commodities is one of the top two challenges faced by the largest energy production companies, followed by economic regulation; Source: Economist Intelligence Unit 2009 There will be large investments required to transform energy production in order to meet the needs of a new fuel balance that is shifting towards gas. In average increase of the world fuel price per annum was 15% 1. The largest fuel price increase per annum was 50% According to Economist Intelligence Unit s forecasts, primary fuel prices will increase by 27%, during The gap between natural gas and crude oil prices will keep increasing, as the former will face competition from shale gas; 1 Compounded annual growth rate 2 Weighted average of oil, gas and coal consumption in Latvia in 2010.

18 18 Business Vulnerability to Changes in Energy Prices in the Baltics Electricity and heat price development in the Baltics Electricity prices in the Baltics EUR/MWh During , the sharpest increase in heat prices occurred in Lithuania (47%), followed by Latvia (43%) and Estonia (39%). During the same period, electricity prices showed the sharpest rise in Latvia (43%), followed by Lithuania (38%) and Estonia (25%) Estonia Latvia Lithuania Approximately 30% of the electricity price and 70% of the heat price are directly influenced by the fuel price. This trend is common in all Baltic states 1. Heat prices in the Baltics EUR/MWh Since 2004, the share of heat price that is directly influenced by primary fuel cost had increased from 40-50% to 70% 1 in (In an attempt to curb the rising heat prices, a larger part of the heat tariff is actually paid out to cover fuel costs, while other expenses for system maintenance and development are reduced) Estonia Latvia Lithuania Source: Lithuanian, Latvian, Estonia Statistical offices 1 According to local heat associations, EC DG-E, electric companies data

19 Business Vulnerability to Changes in Energy Prices in the Baltics 19 Assumptions under the scenario of energy price changes 30% 5% Change in heat price The energy commodities escalation factors used in the simulation model were: 15% Optimistic scenario: 70% 25% Change in fuel price Fuel price increases 15%. Heat price increases 12%. 50% Electricity price increases 10%. Heat price structure (EUR/MWh) Realistic scenario: Fuel price influenced Other Fuel price increases 25%. Heat price increases 19%. Electricity price increases 13%. 70% 30% 8% 15% 25% 50% Change in electricity price Change in fuel price Pessimistic scenario: Fuel price increases 50%. Heat price increases 37%. Electricity price increases 21%. Electricity price structure (EUR/MWh) Fuel price influenced Other Source: European Commission Directorate-General for Energy, EU Energy Trends 2030 The EIU World fuel price index was used to calculate the fuel price escalation factors, as follows: The optimistic scenario uses an average price increase of fuel during ; The realistic scenario uses fuel price increase forecast in ; and The pessimistic scenario uses the largest peak fuel price increase. In the Baltics, heat price is approximately 70% influenced by fuel price escalation. This ratio was multiplied by the expected fuel price escalation factor in each of the scenarios; added to this were the additional 30% costs in heat price structure, escalated by a 5% expected increase in all other heat production costs. For electricity approximately 30% of price was assumed to be affected by fuel price escalation. This ratio was multiplied by the expected fuel price escalation factors in each of the scenarios; added to this were the additional 70% costs in electricity price structure, escalated by 8% expected increase in all other electricity production costs. The base ratios and escalation factors were derived from EC DG-E report and local Baltic heat associations data. The above was simulated for the 2010 results of the surveyed sectors in all three Baltic states.

20 20 Business Vulnerability to Changes in Energy Prices in the Baltics Energy price change scenario results for Estonia Change in net profits of 2010 while modeling different price scenarios Net profit (loss) in 2010 Optimistic scenario Realistic scenario Pessimistic scenario Sector 1. Construction -EUR 37 million -EUR 47 million -EUR 54 million -EUR 71 million 2. Transportation EUR 249 million EUR 186 million EUR 146 million EUR 45 million 3. Agriculture, Fishing, Forestry EUR 110 million EUR 99 million EUR 92 million EUR 75 million 4. Trade and Services EUR 1,010 million EUR 983 million EUR 969 million EUR 934 million 5. Industry EUR 731 million EUR 644 million EUR 592 million EUR 462 million Source: KPMG analysis EUR 2,063 million EUR 1,865 million EUR 1,745 million EUR 1,445 million Based on Realistic scenario results: The following sectors were identified as the most sensitive to energy price escalation: Industry sector (-EUR 139 million), followed by the Transport sector (-EUR 103 million). The following sectors were identified as the least sensitive to energy price escalation: Construction sector (-EUR 17 million), followed by the Agriculture, Fishing and Forestry sector (-EUR 18 million) and the Trade and services sectors (-EUR 41 million). Energy price change scenario results for Latvia Change in net profits of 2010 while modeling different price scenarios Net profit (loss) in 2010 Optimistic scenario Realistic scenario Pessimistic scenario Sector 1. Construction -EUR 184 million -EUR 190 million -EUR 193 million -EUR 203 million 2. Transportation EUR 69 million -EUR 104 million -EUR 220 million -EUR 507 million 3. Agriculture, Fishing, Forestry EUR 178 million EUR 160 million EUR 149 million EUR 121 million 4. Trade and Services -EUR 292 million -EUR 338 million -EUR 360 million -EUR 414 million 5. Industry EUR 105 million EUR 68 million EUR 49 million EUR 0 million Source: KPMG analysis -EUR 124 million -EUR 404 million -EUR 575 million -EUR 1,003 million Based on Realistic scenario results: The following sectors were identified as the most sensitive to energy price escalation: Transportation sector (-EUR 151 million), followed by the Trade and Services sector (-EUR 68 million), and the Industry sector (-EUR 56 million). The following sectors were identified as the least sensitive to energy price escalation: Construction sector (-EUR 9 million), followed by the Agriculture, Fishing and Forestry sectors (-EUR 29 million).

21 Business Vulnerability to Changes in Energy Prices in the Baltics 21 Energy price change scenario results for Lithuania Change in net profits of 2010 while modeling different price scenarios Net profit (loss) in 2010 Optimistic scenario Realistic scenario Pessimistic scenario Sector 1. Construction -EUR 18 million -EUR 31 million -EUR 38 million -EUR 58 million 2. Transportation EUR 132 million EUR 62 million EUR 17 million -EUR 97 million 3. Agriculture, Fishing, Forestry EUR 15 million EUR 12 million EUR 10 million EUR 5 million 4. Trade and Services EUR 589 million EUR 537 million EUR 511 million EUR 448 million 5. Industry EUR 522 million EUR 479 million EUR 457 million EUR 405 million Source: KPMG analysis EUR 1,240 million EUR 1,059 million EUR 957 million EUR 703 million Based on Realistic scenario results: The following sectors were identified as the most sensitive to energy price escalation: Transportation sector (-EUR 115 million), followed by the Trade and Services sector (-EUR 78 million), and the Industry sector (-EUR 65 million). The following sectors were identified as the least sensitive to energy price escalation: Agriculture, Fishing and Forestry sectors (-EUR 5 million) followed by the Construction sector (- EUR 20 million).

22 22 Business Vulnerability to Changes in Energy Prices in the Baltics Conclusions The results of the modelling suggest that Latvia is the most sensitive country in the Baltics to energy price escalation losing an additional EUR 451 of its profits according to the realistic scenario, followed by Estonia (EUR 318, 18% decrease) and Lithuania (EUR 283, 30% decrease). The results of the modelling suggest that Transport and Industry are the most vulnerable sectors of the Baltic economies, whereas the least vulnerable are Agriculture, Fishing and Forestry and Construction sectors. The Latvian Transport sector is much more sensitive to the increase of motor fuel prices due to the fact that fuel cost component in the overall cost structure is approximately 20% larger than in Lithuania and Estonia. Estonia features the most stable economic sectors in the Baltic region, least vulnerable to global economic trends and energy commodity price increase, while Latvia is falling far behind. Lithuanian economic sectors surveyed performed well in terms of profitability, but showed significant volatility in results year on year. In all three Baltic countries, the rate of cost escalation outperformed that of revenue escalation, suggesting the region as a whole is relatively sensitive to any additional cost increases possible due to energy price escalations. Latvia is falling far behind the other two Baltic states, as may be seen in Table 1: Baltic average cost and revenue growth Revenues Costs Lithuania 5.8% 8.2% Latvia 1.25% 2.5% Estonia 5.4% 5.6% The Agriculture, Fishing and Forestry sector in Latvia shows 2-3 times higher profitability than that in Estonia and Lithuania. This could be explained by a spike in the Latvian forest felling in the last three years, allowing for the exploitation of rising fuel biomass prices in Scandinavia to increase the sector s profitability (and not processing the biomass locally to produce added value, local heat and electricity), making this Latvian sector least sensitive to energy price increase. Baltic total forest felling, Thousand m 3 14,000 12,000 10,000 8,000 6,000 4,000 2, Lithuania Latvia Estonia At the same time, Estonian and Lithuanian forest management companies might consider increasing forest felling rates in order to make their respective sectors more profitable (while keeping added value generation in the local market). The Estonian industrial sector is 4.5 times more profitable than the Latvian one and twice the Lithuanian industrial sector, while energy intensity in all three Baltic countries is similar in this sector of the economy, suggesting increased efficiency of the Estonian industrial sector compared to its Baltic pears. In absolute terms, the sharpest rise in electricity prices was experienced in Lithuania EUR /Mwh, while Estonian electricity prices are the lowest in the region (oil shale-based capacities and opening of the electricity market to spot trade); but, in relative terms, electricity prices increased most in Latvia (43%), followed by Lithuania (38%) and Estonia (25%). This trend is explained by the need to introduce large gas fuelled power projects in Latvia and Lithuania to compensate for the generation deficit experienced in each of these countries and the Baltic region as a whole. Heat energy prices increased most in Lithuania in both absolute and relative terms (47% to EUR 68/Mwh), followed by Latvia (43% to EUR 59/Mwh) and Estonia (39% to EUR 44/Mwh), explained by the increased use of gas-fuelled CHP s for heat generation and a sharp hike in gas prices.

23 Business Vulnerability to Changes in Energy Prices in the Baltics 23 The heat and electric energy prices in the Baltics are foreseen to continue rising, impacting significantly the leading Baltic economic sectors surveyed and necessitating the local economies to restructure their economic sector mix (more added value generation), while also striving to decrease the energy intensity of each of the most sensitive economic sectors by increasing energy efficiency. All three Baltic governments need to draw their conclusions and plan mitigation measures to hedge for the energy price escalation trends and the risks they represent to their respective economies: 1. Reduce energy intensity promote energy efficiency measures. 3. Develop financing instruments and fiscal economic incentives to attract FDI and investments into the energy sector. 4. Improve economic regulation of the energy sector, to allow stable, transparent and fair financial returns while protecting end consumer interests. 5. Combine energy sector planning with overall national economic and infrastructure planning. 6. Work to increase institutional capacity of the government and private sector, allowing increased rational use of energy and its production. 2 Use indigenous fuel sources decouple reliance on global fossil fuel price trends.

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