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Vattenfall AB Board . otOir�·elots.-"tet__..

Meeting date: 2014-10-29 Agenda item: 7

Subject: Divestment structure for lignite portfolio (Project Odin)

Sponsor: CEO

Submitting UniUDivision: -

Prepared by Board Committee: N/A

Presenter: CEO (Stefan Dohler, Thijs van Lotringen)

Resolution: 1 X l Information: 1 1 Confidentialit Class

None (C1 ): Medium (C2): High (C3): Critical (C4 ):

Proposed resolution:

lts proposed that the CEO and BoD

i)

ii)

iii)

endorses the proposed divestment strategy for the integrated Lusatian lignite

portfolio (including Lippendorf).

that a formal M&A project will be initiated, Project Odin. to continue working on

this strategy with the aim to present a more worked out strategy including concrete divestment opportunities/transactions proposals in the board meeting of the 17th of December. This work will entail among other also more in depth discussions with potential new shareholders (strategic and public investors) and

potential engagement of advisors (financial, legal, technical)

and that Project Odin encompasses a carve out and operational restructuring of

the current Vattenfall Europe Generation and Vattenfall Europe Mining AG entities towards stand-alone operability to ease a future divestment if a

transaction fails under the proposed divestment strategy.

1 May only be dlsclosed to Board members, presenters to the Board and other persons wlth access to sent-out or stored

Board material.

x1

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1 EXECUTIVE SUMMARY

The upcoming investment decision on Nochten,and the position of the newly elected Swedish

government's position regarding Vattenfall's lignite activites are putting already as such

directly the question on the table: What and under which ownership is the future of our lignite

portfolio? But by taking into account also the upcoming key decisions in the German energy

market which will most likely reshape the market framework significantly and where

Vattenfall's Lignite asset could trigger crucial events on all those decisions this gives Vattenfall now a natural momentum to oosition itsP.lf

· - ·

3. Any outcome of this process and potentiaily concrete transaction cannot be communicated without a very clear strategy for the other activities of Vattenfall in Germany (this is not an exit of Germany, this is an exit out of our lignite portfolio ). This strategic move should represent Vattenfalls ambitions to reshape its portfolio towards becoming a leader in sustainable energy production (with reference to further investments into Downstream, Heat, Renewables - e.g. Sandbank, etc.).

2 BACKGROUND AND RATIONALE FOR A TRANSACTION

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Vattenfall owns up to 8.000 MW of lignite-fired generation capacity in Brandenburg and Saxony, building as such a backbone of the German base load, approx. 7.000 MW thereof in

the Lusatian region which is operated as a highly integrated portfolio with own mining operations. The assets are held by Vattenfall Europe Generation AG (generation portfolio) and by Vattenfall Europe Mining AG (mining portfolio) (hereafter cal/ed M&G) direct subsidiaries of Vattenfall GmbH. The strategy for Lignite has been based on operating the plants until the end of their respective technical / commercial lifetime. However, the existing permitted lignite

reserves in our Lusatian portfolio will not be sufficient to operate the plants until the end of their lifetime since Nochten and Welzow will be depleted by

2.1 Value at Risk

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2.2 Rationale for a transaction

Given Vattenfall's new shareholder's ambition for the company, the widely negative perception

in Sweden of Vattenfalls's lignite operations, German uncertainties in its Energiewende and

the upcoming landmark decision on the expansion of Nochten & Welzow, this all together

gives a natural momentum to decide on the future ownership of Vattenfall's Lignite business.

With the intension of Vattenfall and its shareholder to stay in the "drivers seaf' and to have an

impact on all discussions around this topic, it is important to outline a strategy on how to deal with its future Lignite business before deciding upon Nochten Capex (irrevocable decision due

to the begin of resettlements or negative impact due to delaying) and before further decisions

on the German energy market or in German/Swedish politics will narrow down Vattenfall's

flexibility to act. The assumption is that this natural momentum is open until Spring/Summer

2015 before Capex is spent/disapproved and before potential decisions on the German Energiewende are further advanced (e.g. ruling on nuclear taxation4, discussions on transferring nuclear liabilities- "Bad utility" concept, capacity payments scherr0 strategic state reserves etc.)

3 DESCRIPTION OF THE ENVISAGED TRANSACTION

The total divestment strategy and its envisaged transaction will be subject to negotiations and readiness of our potential partners, which needs to be tested, but the overall direction of the

proposed transaction is mainly based on 3 pillars:

• Constitutional Court and European Court or Justlce rullng ere expected In 2015 Note: Values / Comments In bracilels are s11bjecl to negotlutlons and could l/1erefore change or ff necessary become part of

an egreemenl

„

1)

2)

3) Vattenfall to present a strategy In Germany parallel to the executlon 1

announcement of the divestment strategy

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In order to avoid rumours, uncertainty and negative effects of "Vattenfall is exiting

Germany" it is necessary to present in the same time when announcing an exit in

Lignite how Vattenfall wants to position itself in Germany and potentially how Vattenfall

will use the funds out of that transaction. Negative effects could be an unfavourable

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decision in the Berlin concession process (decision expected in H1 2015) or a general

weak perception of Vattenfall's future in the German energy market after exiting a major part of its German business.

The storyline should include that this is a strategic move and represent Vattenfall's ambitions to reshape its portfolio towards becoming a leader in sustainable energy

production (with reference to further investments into Downstream, Heat, Renewables - e.g. Sandbank, etc.).

Base Case for the legal structure of such a transaction is that the industrial and public investors will acquire shares of M&G.

3.1 Timeplan

As stated before it is considered that the natural momentum to act has started right now (due

to new governments and the uprising discussion around Lusatian lignite portfolio) and will last until spring/summer 2015 before any CAPEX on Nochten decision is to be made. In parallel several unresolved issues regarding German Energiewende will be decided within 2015 (e.g. ruling on nuclear taxation, discussions on transferring nuclear liabilities- "Bad utility" concept, capacity payments scheme, strategic state reserves etc.) potentially reshaping the whole market framework in which Utilities currently operate in. Recently, the Secretary of State in the Ministry of Economics (Mr. Baake, responsible for energy) has tested a proposal to put 5 GW of lignite and 5 GW of hard-coal into a strategic reserve in order to reduce the C02 footprint of the German electricity production. Through that, the pressure on lignite is increasing steadily.

Acting now is key to safeguard not only value and trust but also the only chance to have a certain impact by staying in the "driver's seat". lf Vattenfall loses the momentum it will be dragged into a very lengthv and ooiiticaliv driven p;ocess with limited impact and flexibility to act and potentially losing

Based on the complex situation of facing a major investment decision and uncertain market outlook/framework Vattenfall will need a sequential and carefully timed approach. In order to test the grounds and options for upcoming discussions first meetings with potential lndustrial partners and Stakeholder representatives (e.g. Head of the IGBCE Trade Union) have taken

place .The strategy and its respective timinri 'lims to sian a Mnl 1 I term sheet with relevant parties (at least with the lndustrial partner 1 and to go public as soon as possible, most likely in the time betweer1 1V1arch/April 2015. The MoU I term sheet should build the framework for a transaction which means it will cover all relevant mechanics and represent talks/agreements on structuring, price, financing. Due Diligence principles, closing

mechanism, communication and strategy going forward.

The announcement of this MoU I term sheet itself then implies 2 potential outcomes:

1) The transaction is regarded as favourable and will receive all necessary approvals with intended closing until end of 2015. As such Vattenfall starts

2)

„„„„------------��-.�

3.2

3.3 Potential lndustrlal Partners and status of current discussions

During the past few weeks (pro actively) expressed an interest to Vattenfall to explore options to discuss a future ownership in Vattenfall's M&G

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3.4 Next Steps

The coming months are to be used to test and detail the indicative structure both internally and

extemally and start preparation for a potential transaction. Key (high level) areas to start

worl<ing on are:

1) Internat preparation: Start a M&A project by forming a project team consisting of numerous staff functions and the M&G. Key tasks are detailed legal, tax, valuation analysis, carve out red flag report, preparations for a complete (vendor) DD process. Prepare full leak communication mainly focussed around the Nochten investment.

2) Partnering: reach out to potential industrial investor�

tn <fü;r.11ss structure. interest and process etc.

:, appetite and process.

3) Stakeholder management: workers council, Supervisory Boards etc. to be managed and gradually informed on intentions and overall deal framework

4) Advisors: hiring where needed: potentially Legal, Tax, transaction Services, T echnical, Financial advisor

5) Communication: A carefully carried out strategy needs to be in place as place as soon as this projects starts. The communication strategy should regard 3 phases (confidential phase, pre-announcement phase, and the announcement itself).

During the confidential phase (starting from today up to a proactive public statement by VattenfaH or \ts shareholder) any communication will be a reaction as a result of a leak. Core message should be that Vattenfall is investigating all options to corne with a balanced approach towards potential new investment in lignite mines. This may also include the evaluation of attracting 3rd party capital.

In the period before a pub/ic annoucement on an actual transaction; for

„�.,„ ...... -,.. --

With the signing of a MoU/term sheet follows the public announcemem presenting the full story.

In parallel at corporate level (outside M&A project) it will be needed to initiate the Strategy development for Vattenfall as a whole. and for Germany specifically to be announced with the MoU I term sheet.

Key objective is to be able to have a transaction worked out at the level of signing a MoU I

Term Sheets towards the end of March/April 2015. This is an ambitious target, especially lookinq at the (both formal and informal) decision making models of our identified lndustrial

. lt is only possible if a dedicated team starts working on this project as per

Oct 30.

3.5 Carve-out of M&G

In case of a failed transaction under the proposed divestment strategy, but at least to be prepared for future divestment attempts, the project should encompass a carve out of M&G. Currently relevant assets are owned by two separate legal entities held by Vattenfall GmbH. In addition the Generation entity, Vattenfall Europa Generation AG, entails not only the Lignite

-- - .. - - ·- - - ---

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power plants but also pump storages and the coal-fired power plant Moorburg making as such

a fast and clean Lignite exit more complex.

lt is proposed under considerations of operational, tax and legal issues to ease the current

ownership structure (e.g. carving out Hydro and Moorburg at any case), to alter the overall

cornpany steering (e.g. board composition) and to enable stand-alone operability.

The carve-out of the M&G activities out of the Vattenfall group is to be regarded as "no regret"

step. Even if, in the end, a divestment according to the one described in this document is not

successful it is desired to have M&G placed at arms length and on a full standalone basis,

separated of the other activities of Vattenfall. With a separate set of KPl/targets compared to

the rest of Vattenfall both business of Vattenfall will be governed and evaluated on more fair

grounds.

lt will also create the strategic f\exibility to divest M&G at a later stage if the opportunities

occurs again.

A careful review needs to be prepared on the governance and the composition of the

supervisory board of such standalone M&G company.

3.6 Pre-requisites for success

Being the framework for a successfLt! project hence transaction there are several pre-

requisites that have to be met within the coming months:

Timing- to come up with a MoU /Term sheet until March/April 2015; the decision on Nochten

creates the momentum for all parties to position itself inclusive the discussion

;; so it is the pivotal part of the whole transaction

Strategy- Vattenfall must have its strategy ready at time of announcement to avoid negative

effects of / communication on the preferred transaction

Confidentiality- No leakages before announcement to keep Vattenfall in a pro-active role and

not reactive. lf early communication required, this has tobe focussed on Nochten, not the

German exposure as a whole.

Vatue - Vattenfall must be nreoared to give up on the upside of the

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4 OPENISSUES

A first high-level estimate views the following issues as key to be addressed within the M&A

project for the envisaged transaction:

4.1 Valuation

MWH.!.*

Conanuat1on

of Mochten

& Welzow

No Continuadon

of Hechten

& Welzow

· Valuaöonmelhod � ·

Figure 2: Va/uation range (preflminary)

4.1. 1 Risk of valuation discount

4.1.2 Current regulatory uncertainties

Strategie Reserve

With regards on timing and upcoming discussions on the proposal to put 5 GW of lignite and 5

GW of hard-coal into a strategic reserve one aspect is naturally the economic impact on the

lignite portfolio by such a move. Any investor will value that in, thus Vattenfall cannot expect a

firm valuation while there is no clarity on this issue. lndicated timeline is that the German

cabinet will already discuss the proposal in Dec. 2014 thus a quick decision process seems

possible.

BREF

BREF LCP, a cornerstone of the lndustrial Emissions Directive (IED), provides

recommendations for Best Available Techniques (BAT) and the scope of Associated

Emissions Levels reached in this way. · · · ·

�nanges would apply trom �U19 (possibly later) to all of

Vattenfall's !arger fossil power plant unlts. Vattenfall already took Investment and optimizatlon

measures to complt wlth the requirements of the IED until 2016. Complylng wlth the strlct

-

��-----------------

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emission requirements would mean re-adaptation of the plans before 2019 potentially leading

to further CAPEX needs in M&G.

More clarity on this regulatory issue is expected somewhere in mid 2015 and that may also be

a key factor for any investors.

4.2 Legal lssues

4.2.1 Structurirtg

M&G are separa�e legal entities and part of Vattenfall GmbH. Selling shares of M&G in parallel

is regarded as the bB:,e case; other poss ibilities (but timing wise a challenge for the envisaged transaction) are to push down bott1 entities to be held by a NewCo (and thus selling shares of the NewCo); or Generation AG acquires Mining AG and shares will be sold in Generation AG.

4.2.2 Permits

The current permits are based on an assumed fuel (lignite) demand from the lignite fleet. These permits need to be reconfirmed once the owner want to start digging. lf at that point in time the owner has a significantly reduced generation fleet the question may arise if this reduced demand for lignite is enough to grant the permits of if due to lack of lignite requirements the approval process wouid need to be restarted. The owner could of course argue that he would operate the remaining units longer instead but there is a substantial risk that the nP.rniits are not confirmed. The owner could possiblv steer this bv "sacrificina" e.a. the

>. This issues needs to be treated transparent in any negotiation / due

diligence as this has a major impact on the entire portfolio long-term.

4.3 Group financial impact Basic financial impact on a group-level with a transaction at such magnitude is listed as following:

Rating Vattenfall implications of Vattenfall need to be taken into account since the generation portfolio will be re-shaped significantly (less merchant risk and higher share in regulated business?)

Vendor loan issuing might become necessary

De-consolidation of lignite/mining business

4.3.1 Tail-end rlsk on envlronmental and recultivatlon l/abllities

ls Vattenfall able to leave _all environmental and recultivation liabilities behind if M&G is sold?

Yes f�om a legal perspec�1ve, however, the German mining law allows the authorities to claim secunt1es from an owner m case there are doubts that the future liabilities are not covered suff1c1ently. Today, Vattenfall secures the liabilities through the business itself. However i th mome�t V

_attenfall announ�es

_t�

.e intention to sell it may trigger the authorities to ask fo;

n °

secunt1zat1on of our future hab1ht1es. Authorities cannot enforce a PCG on Vattenfall but could �la1m e._g. a bank guarantee. Also

_any industrial could ask for similar securities 1f th�re 1s awareness that such cla1ms may occur in the future. Vattenfall will need to mana e this �n �he M&A process carefully by ensuring early engagement of the States and the right-

9

wor e announcement regard1ng the future of lignite.

4.4 Tax lasues Any sale of shares in Vattenfall Generation AG .11 b

. . period initiated in 2008 and valid until the end o��015

e ssub

lJlect t3o

O�:eachmg a tax �locking

. e mg ,o ot our shares in 2015

I

'112------------------------

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„

4.5 Carve Out lssues

4.5.1 German Hydro and Moorburg

German HydaG (=PSP) and the.c:dai-fired power plant Moorburg are currently part of the

Vattenfall Generation AG. Prior to -ä sa!e of Vattenfall Generation AG shares of those assets

need to be carved out. The µrar;tica!ities of a carve out / full separation will realistically not be

completed before YE 20�5 Which is also the case for the AOT carve-in, where plant

management and dispatc.:h need to be shifted as weil as the market access function (possibly

after a SLA transition phase) .. A carve-out should be initiated in parallel to here outlined M&A

process which enables fo d?fine the PSP and Moorburg business with a high degree of

precision early on. · .. )� .: "' .� �

4.5.1 Vattenfa/I gro�.· .-

M&G is one of th��gest BU's in Vattenfall's entire organisation and one major service

recipient from all �erent shared services (e.a. VEBS. Holding, AOT). An exit in M&G will

require a comple(carve out (from Vattenfall) �nd carve in (into the new owners landscape). A

carve out in thi.s-;.1t1agnitude can be verv time intense (up to 2-3 years)