China Utilities 12 January 2018 China Gas Gas in 2025: hedging & diversification key for distributors with their eyes on the prize See important disclosures, including any required research certifications, beginning on page 111. China Gas: 12 January 2018 Table of contents Why is growth in natural gas consumption in China 1 5 inevitable? What are the core demand drivers behind solid 2 15 consumption growth of natural gas? 3 Can supply catch up with robust demand? 35 4 Does strong volume growth lead to strong profits? 43 Who stands ready to manage margin risks and 5 51 emerge as a winner? 6 Appendices 61 7 Company Section 72 ENN Energy 73 China Gas 79 Towngas China 85 China Resources Gas 89 Beijing Enterprises 95 China Suntien Green Energy 99 CIMC Enric 103 2 China Gas: 12 January 2018 Contributing Big volume, low tariffs: hedging and diversification key Daiwa Analysts: China’s gas sector had a very strong 2017, with confirmation of a 7%-ROA cap for city- Dennis Ip, CFA gas distribution (excluding residential connection) and massive coal-to-gas (CTG) (852) 2848 4068 conversion of villages in “2+26” northern cities, leading to 30-105% share-price [email protected] appreciation for the China gas stocks under our coverage. Don Lau, CFA With only 6% of primary energy consumption from gas in China, vs. c.25% globally, gas (852) 2848 4469 [email protected] demand is not an issue. But as over 50% of the 320bcm of new demand in 2016-25 will be replacing cheap coal rather than expensive oil products, cost effectiveness is a bottleneck for the wider consumption of natural gas in China. Still, China is committed to clean up its air, and has adopted a radical approach by converting c.3m rural households to gas in the “2+26” major northern cities in China in 2017 with a CNY16bn subsidy. But, we see the CTG subsidy as unsustainable with more users in the future, and a tariff cut as inevitable. After the National Development and Reform Commission’s (NDRC) 8%- ROA and 7%-ROA cap (effective dates of January 2017 and July 2018, respectively) for cross-provincial transmission and city-gas distribution segments, we expect it to push further reforms in the gas sector in 2018-19, including liberalising the upstream and large- user retail market, and further lowering upstream cost and end-user tariffs by taking advantage of the low-cost spot-LNG market. In sum, we expect the national city-gas distributors’ unit gas sales dollar margin to fall by CNY3-5 cents pa, amid 20%/13% YoY volume CAGRs in 2016-20E/2020-25E, with the margin squeeze arising from: 1) ASP discounts offered to CTG customers; 2) Periodic review of distribution tariffs under the 7%-ROA cap policy; 3) Direct-supply threat from oil majors. To offset the profit loss from declining distribution tariffs, especially during winter when market-based gas is at a significant premium, the China city-gas companies can either hedge along the supply-chain by adopting an integrated business model, with cheap LNG from upstream coupled with distributed-energy services for large retail users, eg, ENN Energy (ENN, 2688 HK, HKD51.5), or diversify to other unregulated businesses, such as rural connections, eg, China Gas (CGHL, 384 HK, HKD20.8). However, CGHL is trading at 14.7x 12-month forward PER, vs. 10.8x for ENN. After taking into account the risk-reward profile, we make ENN our top pick and upgrade our rating to Buy (1), and downgrade CGHL to Outperform (2). Given its limited hedging and diversification strategies, China Resources Gas (CRG, 1193 HK, HKD24.7) remains our least preferred city-gas distributor, and we maintain our Hold (3) call. Also, we upgrade CIMC Enric (3899 HK), which looks set for resilient LNG equipment sales from 2018. China city-gas distributors: hedging and diversification (H&D) exposure (CNYbn) 10 Net profit from H&D in 2020E 8 6 4 2 0 CGHL CRG ENN CGHL CRG ENN CGHL CRG ENN 2017E 2020E without H&D 2020E with H&D Source: Daiwa estimates and forecasts 3 Source: Source: NDRC, Daiwa estimates [Need to mention here the company-level revisions to earnings, TPs, and ratings. Otherwise the reader has to go more than 70 pages in to find out what’s changing] China Gas: 12 January 2018 4 China Gas: 12 January 2018 Chapter 1 Why is growth in natural gas consumption in China inevitable? 5 China Gas: 12 January 2018 How far is China from Utopia? In recent years, thanks to more comprehensive and stricter emission regulations, air pollution is easing in China, especially after the implementation of the New Environmental Law in 2015, the first amendment in 25 years, which introduced severe punishments and more importantly offered greater enforcement power to the environmental bureau. As a result, for 2017, China looks set to achieve most of its targets set in the Air Pollution Prevention and Control Plan (大氣污染防治行動計劃 or 大氣十條), a key action plan to mitigate air pollution for 2013-17. China: objectives set in the Air Pollution Prevention and Control Plan Items (µg/m3) Actual level in 2013 Actual level in 2016 Target in 2017 Diff (%) Likelihood to achieve National concentration of PM10 in urban areas 97 82 87 -6% High Concentration of PM2.5 in Beijing-Tianjin-Hebei area 106 71 80 -11% High Concentration of PM2.5 in Yangtze River delta 67 46 54 -14% High Concentration of PM2.5 in Pearl River delta 47 32 40 -20% High Concentration of PM2.5 in Beijing 90 73 60 22% High Source: MEP, Daiwa War against air pollution: just the end of round one While we acknowledge that China has done much to combat the air pollution problem, there is still a long way to go if it is to achieve its desired level of air quality. If we use PM2.5 concentration as a proxy to reflect the extent of air pollution, China still lags well behind the rest of the world — its PM2.5 concentration was more than 30% higher than the world’s average in 2015, not to mention the difference versus developed economies in the West, like the US and EU. In terms of China’s own benchmark, only 25% of Chinese cities passed air quality standards in 2016, with the PM2.5 concentration in the core Beijing-Tianjin-Hebei (BTH) area still 100% higher than the acceptable level. As a result, China is still paying a heavy social cost for its air pollution. According to the Health Effects Institute, an independent research organisation studying the health effects of air pollution based in Boston, 1.1m citizens died due to heavy PM2.5 exposure in China in 2015, representing one-fourth the total number of deaths arising from PM2.5. 2015 PM2.5 concentration comparison China: % of cities that pass the air quality standard (µg/m3) 100% 70 58 60 80% 50 44 60% 40 30 40% 25% 20 15 22% 8 20% 10% 10 4% 0 0% 2013 2014 2015 2016 China EU US World Average Source: World Bank Source: MEP China: PM2.5 concentration in BTH area Numbers of deaths due to PM2.5 exposure in 2015 (µg/m3) (m) 120 106 3.0 2.8 100 93 2.5 77 80 71 2.0 60 1.5 40 1.1 1.0 20 0.5 0.3 0 0.1 2013 2014 2015 2016 0.0 PM2.5 concentration Acceptable level China EU US Rest of the world Source: MEP Source: Health Effects Institute 6 China Gas: 12 January 2018 Don’t underestimate China’s determination to combat air pollution In our view, given the heightened health awareness of its citizens, China’s government will continue to prioritise the task of curbing air pollution going forward in order to maintain social stability, especially in densely populated areas and industrial clusters, including the BTH region, Yangtze River delta region, and the Pearl River delta region. Indeed, the government has continued to roll out new polices and emphasise its reduction targets. For example, in 1H17, the Ministry of Environmental Protection (MEP) launched an air pollution prevention plan (京津冀及周邊地區 2017 年大氣污染防治工作方案) specifically for 2 municipalities and 26 cities (2+26) in the BTH region which clearly defines targets and timelines on restricting the use of coal, diesel vehicles, and the incineration of waste. More importantly, the plan has implemented a much stricter pollutant emissions standard (於京津冀及周邊地區執行大氣 污染物特別排放限值) in order to meet local air-quality goals. We believe the launch of air pollution prevention policies, rising financial support, and stricter enforcement of the overall environmental protection law, as indicated by a sharp increase in the number of environmental crime cases filed and the penalty amounts, demonstrate the country’s determination to put air pollution prevention at the top of its agenda. China: major policies/events on air pollution prevention since 2016 Date Policy/event Description Jan-16 New Air Pollution Prevention Law The Law requires local government and agencies to budget for financial resources to combat air pollution. Local governments and agencies also need to review progress of key air pollution prevention missions periodically. Also, it specifies that environmental treatment targets should be as important as economic goals Dec-16 Environmental Protection Tax Law The Law replaces the old waste treatment tariffs with environmental taxes and allows local government to adjust the taxes upward according to their situation, with the old tariffs being the lower limit. In other words, waste treatment charges have been raised Dec-16 Implementation of Comprehensive The policy aims to reduce the emission of eight heavy-polluting industries including steel, coal-fired power, Emission Target for Industrial and cement by the end of 2017 Polluting Sources Jan-17 Amendment on the Evaluation The weighting of environmental protection and resources preservation have become much higher than that Metrics for Government Officials of GDP on the evaluation of local government officials Mar-17 2017 Report on the Work of the Premier Li emphasised the government’s determination to improve air pollution problem with specific Government targets (eg, 3% emission reduction for sulfur dioxide and nitrogen oxides) Mar-17 2017 Air Pollution Prevention Plan The policy restricts the use of coal, diesel vehicles, and the incineration of waste in the 2+26 cities in the for BTH and surrounding areas BTH area Source: Chinabaogao.com, Daiwa China: central government air pollution China: no.