Vattenfall´s earnings are affected by certain fundamental driving forces and risks, such as electricity prices, fuel prices and political decisions.
Electricity prices are the single most important value-creation factor at Vattenfall. Losses can arise due to changes in the wholesale prices for the electricity that Vattenfall conducts physical and financial trading in. The price of electricity is affected by fundamental factors such as water supply, fuel prices, CO2emission allowances and electricity consumption. To manage price risk, Vattenfall sells and buys electricity through forward contracts. Business in the various electricity markets is handled by Vattenfall Trading Services' market access function.
Plant availability and efficiency/ available generation capacity
Production stops caused by ageing plants or operative problems can cause losses of income. Such losses can be compensated to some degree through insurance. About half of Vattenfall's electricity generation in the Nordic countries is derived from hydro power from Swedish hydro power plants. An increase i the hydrological balance, i.e., water levels in dams, can push down electricity prices, with lower income as a result. The earnings impact of such a drop in prices can be mitigated if electricity has been sold in advance in the forward market. Increased generation can also be sold on the spot market. This risk can be lowered through greater integration between the Nordic region and other markets.
The Group is dependent on the price of coal and uranium, which are fuel for the power plants. However, most of Vattenfall's coal- fired plants use lignite from the Group's own mines. If the market price of hard coal and uranium rise more than what has been assumed in the Group's hedging strategy, it can entail higher costs and — if electricity and heating prices do not follow suit — lower margins. The cost of uranium accounts for a very small part of the total production
cost for nuclear power, however.
Energy and environmental policies
National targets for the share of electricity generation based on renewable resources are rising in all of Vattenfall's markets, which affects our investment plans. The return on such investment projects depends in large part on the subsidy systems. Starting in 2005, most countries in the EU have been allocated quotas for CO2 emission allowances in accordance with the EU burden-sharing agreement. Allocations of emission allowances will be gradually reduced, and quotas will be lowered up until 2012. Higher prices of emission allowances would increase the price of Vattenfall's fossil-based generation, but at the same time, higher income is generated if electricity prices also rise.
Vattenfall Trading Services has been set up to minimise costs and to benefit from the advantages of having a large and central trading unit. The main purpose of this unit is to help the various business units hedge the risks that arise in their business activities and in such way create value-added. The unit serves as a sort of internal bank and is a central function for the Group's transactions on the raw material exchanges. At the same time, a consolidated risk profile can be created at the Group level, and risks in various portfolios and raw materials can be netted against each other.
Vattenfall Trading Services also has its own limited mandate to use its market expertise and take advantage of business opportunities in the raw material markets. The chief risks in this operation consist of volatile electricity and raw material prices, risks that can arise when a counterparty in a transaction fails to meet its obligations, and some currency risk in euros and Norwegian kronor in connection with price hedging of electricity primarily on Nord Pool.
Number of customers/economies of scale
Increasing the number of customers and lowering cost-to-serve are central for economic value creation in Sales.
Greater competition is putting pressure on margins in all of Vattenfall's markets, which is why it is very important to achieve a high level of cost effectiveness.
Major customers often require long-term, complicated contracts that are specially adapted for their respective operations. The Vattenfall Group tries to the extent possible in the market to hedge the risks that can be associated with these types of contracts.
If a customer fails to meet its payment obligation, this can lead to a loss of income. Vattenfall uses external rating information when such is available. If the company does not have an external credit rating, internal models are used to determine the counterparty's creditworthiness. Limitations in trading volume are continuously evaluated for each counterparty.
Changes in temperature and in the economy can result in customers using more or less electricity than expected. This gives rise to a risk that delivered volume will differ from what was planned. Vattenfall manages this volume risk by improving and developing processes for electricity consumption and, as a rule, taking it into consideration when setting the terms and conditions of contracts with customers.
Regulation of network activities
In Germany, Finland and Sweden, new models have been introduced for regulating network tariffs. These models have been formulated to encourage network operators to increase the efficiency of their respective systems and at the same time allow for a reasonable return on invested capital. In Germany, demands are being made to expand the distribution network to allow it to accommodate a higher percentage of wind power. The new regulations are putting downward pressure on network tariffs, with the risk that the costs associated with the expansion will not be fully covered.
Variations arise in network loads over the short and long term. It can be very difficult to predict how large these variations will be. This risk is managed through careful follow-up of outcomes in relation to hedged volumes. For deviations that are judged to be enduring, the volume target is changed for hedges for future periods.