Fitch Ratings says that the German energy utility sector remains relatively well protected against the country's current recessionary environment. However, the impact of the downturn on earnings and cash flows varies across companies depending on factors such as the effectiveness of hedging strategies and trading activities, the degree of customer and geographical diversification, the composition of the generation mix, and the contribution of stable regulated activities to consolidated earnings.

"Due to the economic slowdown and related contraction in energy demand and prices, the operating margins and cash flow generating ability of German utilities are likely to come under some pressure, but not to the extent that it will affect ratings in the near term," says Jacek Kawalczewski, Associate Director in Fitch's Energy, Utilities and Regulation team. "The operating performance of the main German players is supported by their well-balanced generation portfolios, diversified customer base and comprehensive hedging strategies. These factors will help the utilities to endure a more prolonged decline in energy demand, historically low spot market prices and an up-tick in bad debtors."

Despite the dramatic decrease of more than 40% in energy prices on the German Energy Exchange (EEX) since peak levels reached in mid-2008, and a 5% year-on-year demand contraction, the EBITDA performance of German utilities remained relatively strong in Q109. E.ON AG ('A'/ Stable) reported a y-o-y adjusted EBITDA decline of 3%, compared with an increase of almost 5% for RWE AG ('A+'/Negative) and a rise of 7% for EnBW AG ('A'/Stable). These results were partially possible due to the utilities' strategy of selling almost their entire generation output one or two years in advance through forward contracts, which have proven effective in limiting earnings volatility, especially if supported by comprehensive trading activity. However, in the absence of an upward pricing adjustment, utilities will likely feel some pain as forward contracts reach maturity.

Fitch also believes that the increase in exposure to distressed industrial customers with whom the utilities have entered into take-or-pay forward contracts might hurt supply margins, as the energy supplies that cannot be absorbed by these customers will typically be resold at subdued spot market prices. Fitch therefore carefully assesses the quality of forward contracts and trading activities, the breakdown of customers for individual utilities and the mechanisms in place for monitoring counterparty risk.

Q109 results revealed that the three main German utilities experienced material declines in energy demand, especially in the industrial customer segment, which saw a 13% y-o-y reduction. Fitch believes that utilities whose customer base is more targeted towards households and local utilities (Stadtwerke) are relatively better positioned in the current environment as they should be less affected by negative swings in energy demand.

Fitch notes that the geographical spread of operations can materially affect performance, with E.ON AG being the most international of the German utilities A number of European energy markets have been impacted more than Germany for instance, with Q109 demand in the UK and Russia down by more than 6%, and declines of almost 8% seen in Spain and Italy.

Fitch anticipates that worsened economic conditions will encourage German utilities and their European peers to implement efficiency measures in addition to those required under the new German incentive-based regulation that is binding from January 2009. However, the binding efficiency gains are unlikely to be visible by end-2009.

The agency will continue to comment on the performance of German utilities and their peers in the EMEA region in the context of the subdued demand and pricing environment.