RISKS

The main risk inherent in exploration activities is the risk of failure to discover hydrocarbons, i.e. exploration risk. This means that not all identified leads and prospects actually have deposits of hydrocarbons which can qualify as an accumulation. In addition, the actual quantity and quality of accumulated hydrocarbons may differ from estimates. If the results of successful exploration in the form of new reserves do not balance production from existing fields, the recoverable reserves in the PGNiG Group’s fields will gradually decrease as the production continues.
Reserves estimates and production projections may be erroneous due to imperfections inherent in the applied equipment and technology, which affect the quality of the acquired geological information. Irrespective of the methods applied, data on the volume and quality of commercial reserves of crude oil and natural gas is always an estimate. Actual production, income and expenses relating to a given deposit may significantly differ from estimates. The weight of this risk is further increased by the fact that in the full business cycle the period from start of exploration to the launch of production from a developed field takes six to eight years, while the production lasts from 10 to 40 years. Formation characteristics determined at the stage of preparing the relevant documentation are reviewed after production launch. Any downward adjustment of the reserves or production volumes may lead to lower revenue and adversely affect the PGNiG Group’s financial performance.

Both in Poland and abroad there is a risk of competition from other companies seeking licences for exploration and appraisal of hydrocarbon deposits, although it should be noted that this risk has significantly diminished in the Polish market over the past year. Certain competitors of PGNiG, especially those active globally, enjoy strong market positions and have greater financial resources than those available to the Group. Thus, it is probable that such companies would submit their bids in tender procedures and be able to acquire promising licences, offering better terms than PGNiG could offer given its financial and human resources. This competitive advantage of oil majors is particularly important on the international market.
Competitors seek to increase gas fuel sales by offering competitive prices of the fuel or dual fuel (gas and electricity) deals. A noteworthy development is also the growing activity of large energy companies on the Polish natural gas market.
Given the prevailing trend in supplier switch numbers (according to URE data), the number of people switching energy supplier should increase in the coming years.

These factors materially delay investment activities and entering the area to commence construction work. Further, PGNiG’s obligation to comply with the Public Procurement Law frequently protracts tender procedures. A protracting project exacerbates the risk related to estimation of capital expenditure.

The need to ensure compliance with environmental laws in Poland and abroad may significantly increase the PGNiG Group’s operating expenses. Currently, the Group incurs significant capital expenditure and costs to ensure compliance of its operations with the ever more complex and stringent regulations concerning safety and health at work, as well as environmental protection. Offshore upstream operations carry a significant risk of environmental pollution resulting from oil spills. The risk is monitored on an ongoing basis, and field operators have implemented a number of barriers and technical solutions to mitigate the risk.

Capital intensity of an exploration project depends on prices of energy and materials. Cost of exploratory work is especially sensitive to steel prices, which are passed onto prices of casing pipes and production tubing used in drilling. An increase in prices of energy and materials translates into higher costs of exploratory work. Profitability of foreign exploration projects also depends to a significant extent on prices of oil derivative products and on exchange rates. To reduce drilling costs, in 2011 PGNiG introduced the daily rate system into its procedure for selecting drilling contractors and paying for their work.

Hydrocarbon deposits developed by the PGNiG Group are usually located at great depths, which involves extremely high pressures and, in many cases, the presence of hydrogen sulfide. Consequently, the risk of hydrocarbon blowout or leakage is very high, which in turn may pose a threat to people (employees and local population), the natural environment and production equipment.
In Norway, PGNiG UN keeps records of all risks related to upstream operations as they arise. All risks are reviewed every three months by an interdisciplinary team of experts. A set of preventive measures is assigned to each risk, designed to reduce the probability and impact of potential accidents.

In some countries, exploration and production activities may be hindered by frequent and unexpected changes in legislation, which may give rise to particularly serious risks in countries with authoritarian regimes. The risk is low in Norway, given the country’s stable legal regime governing the oil industry operations.

Some countries where the PGNiG Group is conducting exploration and production activities are threatened by conflicts and terrorist attacks, which may lead to limitation, suspension or even discontinuation of such activities.
The PGNiG Group’s operations are also exposed to the risk of social or political unrest in some regions. Changes of governments may result in withholding issuance of petroleum licences. Those countries are also at risk of internal conflicts and civil unrest due to poverty and demographic issues. If these risks materialise, the Company’s operations may be limited, suspended or discontinued.
In certain countries, operations of exploration companies may be hindered by the absence of adequate infrastructure, which may be an obstacle in transporting equipment, personnel and materials to the sites. Problems may also arise in providing supplies and ensuring appropriate health care. These risks may lead to limitation or suspension of the Company’s exploration activities.

In 2019, there were protests from residents of the areas where drilling work was being conducted. The reasons for the local communities’ complaints included noise emitted by the drilling equipment, increased vehicle traffic and road destruction, as well as concerns about pollution of the natural environment (water, soil). Protests result in delays or suspension of drilling work, prolongation of administrative procedures and damage to the Company’s image. In order to minimise the risk, the locations of wells are reviewed in terms of potential conflicts and dedicated information campaigns are conducted. It is increasingly more common that local communities expect to receive direct benefits.

Gas trading on the exchange market has been excluded from the tariff regime. Prices of gas paid by end users have also been gradually liberalised as the process of deregulation advances. The first customer groups in respect of which the tariff requirement will be disapplied are wholesale and business customers. As regards gas trading on the Polish Power Exchange or direct sales to customers at prices similar to those quoted on the exchange, there is a risk that revenues from such sales will be lower than gas procurement costs due to the growing disconnect between the market prices of gas and of petroleum products, to which gas prices under the long-term import contracts continue to be linked. As a consequence, revenue is subject to forecasting risk. Inaccurate estimates of costs (particularly the cost of gas purchase) may result in a risk of miscalculation of selling prices and charges, which may adversely affect financial results.
Dependence of PGNiG OD’s revenue on tariffs approved by the President of URE is the key factor affecting the company’s regulated business. Tariffs are crucial to the company’s ability to generate revenue that would cover its reasonable costs and deliver a return on the capital employed. Currently, a significant portion of that revenue depends on the selling prices of gas fuel and is regulated. Inaccurate estimates of demand for gas (affecting the accuracy of projected purchase volumes) and changes in prices of gas purchased on the Polish Power Exchange, which cannot be accurately projected, may have an adverse effect on the financial performance of PGNiG OD.

In 2019, there were no disruptions in gas supplies from across Poland’s eastern border. However, due to the continuing fragile situation in Ukraine and the nearing expiry of the transit agreement between PAO Gazprom and NAK Naftogaz Ukraine at the end of 2019, there was a risk of limitations or suspension of natural gas supplies. PGNIG made preparations in case of suspension of gas supplies as of January 1st 2020. Eventually the transit agreement between Russia and Ukraine was signed and the continuity of gas supplies was maintained.

PGNiG is a party to long-term take-or-pay contracts for gas supply to Poland, and takes care to duly discharge its obligations under those contracts. Assuming that PGNiG’s customer portfolio remains unchanged, the volume of gas imports specified in the take-or-pay contracts will allow the Company to optimise its gas purchases under long-term and spot contracts, including for LNG. If PGNiG loses its market share, there is a risk that the Company would be forced to look for new ways to utilise the surplus volumes of gas in its portfolio.

Limitations at the entry points to the distribution system result from the limitations of the supply network and the insufficient capacity of gas stations. Consequently, the possibility of connecting new customers and gas network roll-out may be limited. In addition, end users may switch to direct or substitute competitors.

The risk is related to the lack of URE’s approval for freezing the tariff prices. If the risk materialises, it may bring about reductions in tariff rates and difficulties in having each subsequent tariff approved. A protection against materialisation of this risk is the development of a regulatory and econometric model, subsequently agreed with URE.

The risk arises from failure to secure a permanent legal title to property at the stage of project execution and property owners’ higher awareness of the related legal aspects. The consequences of materialisation of the risk include excessive (above market prices) claims made by property owners, increase in litigation, litigation costs, claims for removal or alteration of infrastructure, as well as provisions and claims related to extra-contractual use of property.

The substitution risk is associated with a potential lower cost of using alternative fuels and with unavailability or insufficient capacity of the gas network. The risk may arise from the inability to use a wide range of marketing tools due to the nature of the business (separation of distribution and sales operations), from the direction of changes in the national energy policy, and from fuel prices on commodity exchanges. Materialisation of the substitution risk may result in constraints for the roll-out of the programme to connect new areas to the gas network or may affect revenue and volume growth. It may also impair the efficiency of the networks built.

This risk may result from fund allocation priorities set by the institutions responsible for distribution of EU funding. Unfavourable fund allocation may result in unavailability of financing for submitted projects or in low efficiency of such projects.

This risk may result from an insufficient number of qualified contractors, deteriorated competitiveness in the contractors market, and increase in the cost of labour, materials and services. Should this risk materialise, implementation of planned investment processes may be slower than expected.

The volatility of electricity prices is one of the key risks affecting the Company’s financial performance. Towards the end of 2019, there was a strong decline in electricity prices on the wholesale market. Sales of electricity are conducted by the Company in accordance with certain rules limiting exposure to periodic price volatility. In 2019, the adverse impact of lower prices on the results was mitigated by forward sales.

The Company purchases CO₂ emission allowances in quantities representing the difference between actual emissions and the emissions covered by free allowances it receives. In 2019, the prices of emission allowances were less volatile, after a significant increase in 2018. Purchases of CO₂ emission allowances are made subject to specific rules, in particular with respect to the time horizon of the purchase transactions and focus on performance.

In 2019, the main feedstock used for generation purposes by PGNiG TERMIKA was coal, followed by biomass. The volatility of coal prices on the Polish market was not high in 2019, and in addition the Company used coal purchased under contracts executed in previous periods. Matching the timing of sales of electricity and certificates of origin with the timing of fuel purchases makes it possible to partly to mitigate the adverse impact of rising fuel prices on the Company’s financial performance.

Coal is purchased by the Company mostly under contracts executed in advance to ensure that strategic coal stocks are maintained above the level required by the Regulation of the Minister of Economy. Coal transport services are purchased in accordance with the Public Procurement Law.
The Company monitors and forecasts the performance of its contracts and the mandatory stock volumes.

With installations adapted to meet the requirements expressly stated in the Industrial Emissions Directive (IED), the next step will be to ensure compliance with emission limits imposed under the decision establishing the BAT Conclusions for large combustion plants. The deadline for compliance is August 17th 2021 or, where an IED derogation applies to an installation, the end date of the relevant derogation period. An investment plan has been developed for the Company to ensure that the emission and technology requirements defined in the BAT Conclusions are duly met. The process of obtaining amendments to integrated permits in connection with the adaptation to the BAT requirements is in the final stage. Also, the implementation of the BAT Conclusions is monitored on an ongoing basis and any doubts as to their interpretation are clarified.