China / Hong Kong Industry Focus China Gas Utilities Sector Refer to important disclosures at the end of this report DBS Group Research . Equity 29 Sep 2017 More upside in the re-rating cycle HSI : 27,513 ANALYST · Coal-to-gas conversions will continue to drive Tony WU CFA +852 2971 1708 gas volumes and new connections [email protected] · Market has underestimated the potential of Patricia YEUNG +852 2863 8908 rural coal-to-gas conversions [email protected] · Decline in natural gas end user selling prices will drive up demand in 2018 Recommendation & valuation · More upside from sector re-rating cycle; our top picks are ENN (2688 HK) and China Gas Company Price Mkt Target Upside/ Recom 17F (384 HK) Cap Price (downside) PE HK$ US$m HK$ % x Coal-to-gas conversion is the key. Coal-fired boiler Enn Energy 53.45 7,400 66.00 23% BUY 14.4 Holdings* conversions and rural coal-to-gas conversions will serve as (2688 HK) key drivers for natural gas demand and we believe the market has not fully factored in the growth potential, China Gas 22.90 14,563 27.10 18% BUY 19.1 especially for rural coal-to-gas conversions. We reckon rural Holdings*# (384 HK) coal-to-gas conversions is one of the main tools for the government to reach its gas consumption target. Thus, this China 26.60 7,572 n.a. n.a. NR 15.2 will bring about the government to introduce additional Resources Gas Gp. (1193 HK) policies to expand coal-free zones and extend subsidy schemes. We expect natural gas consumption to rise above Towngas China 5.29 1,875 n.a. n.a. NR 12.2 330bn cubic metres (m3) by 2020, and conversion of coal- (1083 HK) fired boilers and rural coal-to-gas conversion will contribute Beijing 40.90 6,607 n.a. n.a. NR 7.9 more than 25% and 12% respectively of gas consumption Enterprises growth during 2015-2020. Hdg. (392 HK) Demand boost from price drop. We reckon the market is Based on closing prices as at 26 Sep 17 too conservative in gas volume growth in 2018. We expect # FY17: FY18; FY18: FY19 gas volume will be boosted by higher usage volume of existing customers and lift in new connection in 2018, on Source: Thomson Reuters, DBS Vickers the back of continued decline in gas selling price, lower pipeline transmission tariff and non-residential dollar margin. Contrary to market expectations, we believe the net effect is positive despite the drop in dollar margin as volume growth outweighs margin cuts, helped by further declines in intra- provincial transmission tariffs. ENN and China Gas are our top picks. We are initiating coverage with BUY ratings on ENN (2688 HK) and China Gas (384 HK). ENN and China Gas are our sector top picks as they are expected to enjoy high gas volume growth from coal-to-gas conversions and would be least impacted by dollar margin decline. ed- JS/ sa- DL Industry Focus China Gas Utilities Sector Table of Contents Coal-to-gas conversion to boost demand 3 Lower gas price to boost demand 7 Top stock picks: ENN and China Gas 14 Stock Profile Enn Energy Holdings 16 China Gas Holdings 24 Beijing Enterprises Hdg. 32 China Resources Gas Gp. 34 Towngas China 36 Appendix A lucrative industry with bright prospects 38 Page 2 Industry Focus China Gas Utilities Sector Coal-to-gas conversion to boost demand tons/hour) are required to be closed; 2) Each of the 28 cities needs to convert 50,000 – 100,000 households for coal-to-gas We believe coal-to-gas conversion will be the key driver in or coal-to-electricity conversion; 3) strengthening scattered coal driving gas sales volumes and new connection fees for gas replacement measures in rural regions distributors in the next two years. We reckon the growth potential is underestimated by the market, especially rural coal- More coal-fired boilers to be converted. The State Council to-gas conversion. We expect demand from coal-fired boilers targets to convert 189k steam ton/hour (t/h) of industrial coal- will remain strong as boilers between 10-35 steam t/h will face fired boilers by 2020, which is expected to boost natural gas stricter regulation, and rural coal-to-gas conversion is expected demand by 38bn m3. This accounts for >25% of the gas to accelerate going forward. volume growth in China during 2015-2020, becoming a key task for the government to tackle in order to achieve its gas Coal-fired boilers and rural coal-to-gas conversion is crucial in consumption target. government’s plan to reach its 13th Five-Year-Plan (FYP) target. The natural gas demand generated from coal-fired boilers The “Action Plan on Prevention and Control of Air Pollution” conversion and rural coal-to-gas conversion is estimated to promulgated by the State Council seeks to take measures to account for >25% and >12% of the increase in natural gas reduce air pollution in China. One of the main targets is to shut consumption during 2015-2020. Therefore, the local small coal-fired boilers (<10 t/h) in cities above prefecture-level governments will need to ensure strict implementation of by 2017 and replace these with cleaner sources including policies in order to reach their respective targets. natural gas. As the assessment deadline approaches, an increasing number of local supplemental policies are being As the first mover tackling coal-to-gas conversion and with rolled out. Strong execution to shut down or convert coal-fired high exposure to Beijing-Tianjin-Hebei region, we believe China boilers were also seen starting in 2H2016. Gas and ENN will be the major beneficiaries. We expect the gas sales volume growth for China Gas and ENN to achieve above After closing down the small size boilers, we expect the the industry average of c.15% at 40% and 32% respectively in government to start tighten the environmental policy by FY17. shutting down or convert coal-fired boilers between 10 steam t/h to 35 steam t/h soon, which will be positive to the market Beijing-Tianjin-Hebei area will be the focus. Coal consumption sentiment. In fact, core cities such as Tianjin and Shijiazhuang in Beijing, Tianjin, and Hebei surrounding regions account for has already implemented tighter policy. According to the one-third of total coal usage in China, thus reducing coal General Administration of Quality Supervision, Inspection and consumption in the area is a major uphill task. In Feb 2017, the Quarantine of the PRC, the amount of industrial coal-fired government issued the 2017 Action Plan on Prevention and boilers below 10 t/h are similar to coal-fired boilers between 10 Control of Air Pollution for Beijing-Tianjin-Hebei regions to t/h – 35 t/h, indicating there are plenty of room for further ensure that targets are met this year. The action plan focuses conversion. on tackling 28 cities in Beijing, Tianjin, Hebei, Shanxi, Shandong, and Henan. Important measures related to coal-to- gas conversion include: 1) Small coal-fired boilers (<10 steam Page 3 Industry Focus China Gas Utilities Sector Recent policies related to coal-to-gas conversion Policy Details related to coal to gas Tianjin 2017 Tianjin air pollution prevention plan (天津 2017 Ø By end of October, establishment of high polluting fuel restriction zones in the city. 年大气污染防治工作方案) Complete the establishment of “no coal zone” in Wuqing District’ and carry out clean energy replacement for 610 villages, 187,000 households (109,000 households : coal to electricity; 78,000 households : coal to gas/other alternative clean energy) Complete conversion or closure of 2,091 t/h of heating coal-fired boilers (capacity <35 t/h). Complete 1,190 steam tons of heating coal-fired boilers (>35 t/h) conversion or closure. Complete conversion or closure of industrial coal-fired boilers representing capacity of 1,950 t/h of industrial coal-fired boilers’ conversion or closure. Hebei 2017 Shijiazhuang air pollution prevention plan (石家 Ø Before the end of October, eliminate coal-fired boilers with capacity of 10 t/h or below 庄市 2017 年大气污染防治工作方案) in the city’s administrative region. Eliminate coal-fired boilers (<35 steam tons) in the city’s built-up areas. Promote the replacement of coal with heat, gas and electricity. Achieve to be “coal- free” in main city areas by 2017. Scattered coal handling plan in rural area for Hebei Ø Reach 6 million or more users by 2020 for coal-gas / coal-electricity Province (河北省农村散煤治理专项实施方案) Special implementation plan for coal-fired boilers in Ø By the end of October 2017, eliminate 11,441 tons coal-fired boilers across all Hebei Province (河北省燃煤锅炉治理专项实施方案) provinces and cities. Coal-fired boilers have priority to connect to centralised heating network. For areas without centralised heating network, encourage gas/ electricity/clean energy to replace coal Substandard coal handling control policy in Hebei Ø 1.8 million households will complete conversion to clean energy in the “no-coal zone” Province (河北省劣质散煤管控专项实施方案) in Hebei Province this year. Henan Henan Province’s coal to natural gas policy (河南省天 Ø Aim to increase kitchen usage of natural gas for >100,000 village households and 然气替代煤专项方案) increase natural gas usage to 20m m3 by 2020. Continuous effort in fighting air pollution Ø By 2017, conversion of scattered coal to natural gas usage will reach 80m m3, with transmission in Henan Province 2017 (河南省 2017 年 40k of village households using natural gas in kitchens across the province. 持续打好打赢大气污染防治攻坚战行动方案) By August 2017, demolish or convert 902 units (<10 t/h) of coal-fired boilers in Hebei- Tianjin-Beijing’s key air pollution control areas including Zhengzhou, Anyang, Hebi, Xinxiang, Jiaozuo Shandong 2017 air pollution prevention plan details for Ø By October 2017, each of the 7 key cities will complete the conversion from coal to Shandong Province(山东省<京津冀及周边地区 2017 gas/ electricity for 50,000 – 100,000 households in total.