Energy prices in Europe reached record highs in the third quarter of 2022. While this is likely to translate into higher earnings for many of the continent's major power and gas utilities, the risk of regulatory intervention weighs on stock performance.

Most utilities are forecast to post higher earnings in the third quarter compared to the year-ago period, according to an S&P Global Commodity Insights analysis of S&P Capital IQ consensus estimates. At the same time, the STOXX Europe 600 Utilities index is down 21.33% year to date, with major utility names such as Enel SpA, Ørsted A/S and E.ON SE underperforming the wider market.

UBS analysts noted that utilities had largely enjoyed a good start to 2022 before performance collapsed in September as interest rates began to rise and regulatory risk in the sector increased.

Month-ahead gas prices on the Dutch Title Transfer Facility peaked at €319.98/MWh in late August as year-ahead power contracts in Germany reached a record €985/MWh. The European Commission proposed introducing windfall taxes, including on renewable energy generators, to claw back some of the power sector's surging profits.

For utilities, the derating "has been severe," the UBS analysts said in an Oct. 24 note.

Analysts at Barclays said the sector's underperformance is "unjustified" since it will ultimately profit significantly from increased capital expenditure and higher energy prices. Many utilities posted strong results in the first half of 2022 with some raising their financial guidance.

"A positive re-rating of primary energy producers (which many European utilities are) is warranted, in our view, particularly given the consensus EPS upside for 2023 and beyond when unhedged generation volumes are materially higher," the Barclays analysts said in an Oct. 12 note. "Instead of focusing on the positive backdrop of a high European energy price world, the market remains (wrongly, in our view) concerned about and focused on perceived tail risks, particularly relating to politics."

The sharp increase in European gas prices in the third quarter was driven by Europe's rush to fill its gas storage reserves amid squeezed pipeline deliveries from Russia. The price volatility meant traders needed to provide ever-higher levels of collateral, putting pressure on cash reserves and credit lines.

Among the worst-affected players was Germany's Uniper SE, which relied heavily on Russian contracts and needed to buy on the spot market. For majority owner Fortum Oyj, Uniper became a liability to the extent that, on Sept. 21, the German state agreed to take ownership of the stricken company.

For its part, Fortum has vowed to return to its Nordic roots as it redefines its strategy in the coming months. The Finnish utility also plans to exit the Russian market, a move completed by Italian peer Enel on Oct. 13.

The third quarter was also dominated by national and EU-level debate over market interventions and market design. Germany decided to abandon a price pass-through which would have allowed utilities to pass on to consumers 90% of the extra costs incurred on the gas spot market. Instead, Europe's largest economy embarked on a €200 billion spending spree to protect companies, households and even certain gas companies from the fallout of surging prices.

Beyond its windfall tax proposals, the European Commission agreed further emergency measures on demand reduction, including the requirement to cut power consumption by 5% at peak hours when extra capacity, usually gas-powered, is most expensive. A blanket cap on gas prices is still pending, however, with some EU member states concerned over unintended consequences for the supply of gas cargoes.

Coal and nuclear are becoming ever-more important in the wider EU power mix, as switching from gas remains favorable and countries like Germany move to allow nuclear reactors to continue operating beyond their previously defined closure dates.

Certain coal plants in Germany have also reentered the market from standby, spelling upsides for owners. RWE AG will continue to operate 2.1 GW of lignite capacity, resulting in an annualized EBITDA upside of more than €700 million, according to Morgan Stanley estimates.

The return of coal and the life extensions for nuclear have been necessary due to severe French nuclear outages as well as abnormally low hydro production in France, Iberia and Italy. The latter poses a risk to some utilities' earnings, according to analysts at Morgan Stanley.

"With hydro reservoir levels still close to record lows in these countries, full normalization may take some time to materialize," the analysts said in a note. "For [EDP - Energias de Portugal SA, Iberdrola SA, Endesa SA] and Enel, we think this could lead to further expensive power volume buybacks (though the negative impact should be more moderate than in [the first quarter of 2022], given the gas price cap and potential offsets from strong thermal activities)."

It was not just coal joining the grid. Ørsted brought online the world's largest offshore wind farm, Hornsea 2, in late August, and is set to cash in on a rule that allows U.K. developers to delay the start of their fixed-price contract for difference. This means the project will receive the wholesale price of power through the winter, possibly limited by a U.K. windfall tax on renewables.

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