7.3. Impairment of non-financial non-current assets

Property, plant and equipment is the biggest item of the Group’s assets. Several main factors have been identified which could significantly affect the asset levels:

• Curtailment of access to mining and drilling services followed by a sharp increase in prices – during the crisis on the coal market all companies suppressed their capital expenditures in the mining and drilling area to the necessary minimum in order to preserve financial liquidity. A consequence of this was that a number of companies specializing in mining and drilling services were shut down and others resorted to dramatic job cuts. As the coal prices began to improve, mining companies, with a view to maintaining their production capacity, resumed their investment projects aimed at accessing new deposits, but the mining services market was not ready to meet the growth in demand from the sector. The shortage of production capacity in service companies coupled with the higher demand for drilling and mining services translated rapidly into sharp price hikes, as was reflected in the tender procedures conducted in 2017.

In 2018, we observed a considerable surplus of supply of mining work, including capital, over the capacity of external companies. Nearly every material tender exceeded the planned value. The companies remaining on the market started taking advantage of the situation, demanding very high prices, which resulted in a considerable increase in expenditures towards drilling and mining services and capital expenditures. Some measures taken by the Parent Company, such as shorter payment terms for external companies selected through tenders, or increasing competition by ensuring that JZR Sp. z o.o. participates in consortia as a member, increasing the number of meters drilled by in-house teams, should lead to higher competitiveness and lower price increases in the future. The market of external service providers has relatively high inertia, so we still have not observed any reduction in prices for services; however the sudden increases have stopped. The average cost of drilling 1 meter of headings commissioned under UWG has been analyzed. The analysis shows that unit price increased significantly as compared to 2017 (fewer meters of headings were executed, at higher unit prices).

• The rise of prices of steel products used in the deep mining sector continued in 2018, which will translate into higher operating expenses and capital expenditures. The year on year increase was about 8% based on a basket of 370 steel products.
• The need to amplify capital expenditures results from the desire to maintain production capacity in the long run – the Restructuring Program, which was executed in a period of low coal prices, was intended to ensure financial liquidity to enable the payment of liabilities resulting from the bond issue. The maintenance of liquidity was planned to be achieved by suspending all key investment projects. The savings program brought about a side effect in the form of the lowering of JSW’s production capacity in the long run, which translated into a plunge in expected output after 2022 by approx. 1.5 million tons. In order to maintain production capacity, it is necessary to resume and accelerate key investment projects in the years 2018-2022 intended to access new deposits, while taking into account the aforedescribed price hikes. An analysis of increases in capital expenditures shows significant growth in 2018 vs. 2017, which indicates that the impairment charge in 2017 was justified. It was caused by the larger material scope (rebuilding infrastructure, IT, OHS, environmental protection and rebuilding the machinery after the crisis on the coal and steel market, relaunch of most strategic capital expenditures) but also higher prices of machinery equipment as well as capital headings (higher prices, higher margins of external companies). This indication has not subsided; to the contrary, in some CGUs it required additional charges.
• The need to increase headcount compared to the previously assumed numbers resulting from the observed decreasing output potential of the mines. Reducing personnel costs through job cuts entails a slump in output volumes in the long run. For this reason, the Strategy for 2018-2030, as compared with earlier plans, takes into account the need to increase headcount (partly through job shifts within the Group): for KWK Budryk by approx. 430 staff by 2021 and for KWK Knurów-Szczygłowice by approx. 570 staff by 2021. For the needs of the impairment test, the Financial Model assumed higher employment as compared to the headcount assumed in the December 2017 strategy, in connection with:
• reconstruction of the employment base after the crisis, to the extent required to ensure correct operation of the Mine,
• larger extent of drilling work planned to be completed, including much larger extent to be executed in-house,
• reduced scope of subcontracted services.
• Expiration of the salary agreement dated 23 February 2015 and an early withdrawal from certain provisions resulting from this agreement, which resulted in higher payroll expenses in 2017 and 2018 and signing of the salary agreement of 11 June 2018, which will result in an increase in wages in the coming years.

Considering the above, it was found necessary to carry out an impairment test for the following CGUs:

• KWK Borynia-Zofiówka-Jastrzębie, Borynia Section
• KWK Borynia-Zofiówka-Jastrzębie, Zofiówka Section
• KWK Budryk
• KWK Pniówek
• KWK Knurów-Szczygłowice.

The impairment tests were carried out for cash-generating unit through determining their recoverable value. Determining the fair value for very big asset groups for which there is no active market and there are very few comparable transactions is subject to an estimation error. In the case of entire mines for which the value in the local market needs to be determined, there are no observable fair values. Consequently, the recoverable value of the analyzed assets has been determined on the basis of estimation of their value in use using the method of net discounted cash flows on the basis of the financial projections prepared for 2019-2023 for the purposes of the impairment test.

For these mines, the assumed economic useful life goes beyond 2023, hence the residual value has been determined on the basis of the remaining period of use. Adoption of five-year financial projections is justified due to the fact that in the current economic situation there are no reliable data for the next reporting periods due to significant volatility of different types of factors, such as: prices, inflation rates, exchange rates and interest rates.

Below are presented the assumptions that have been made for the impairment test as at 31 December 2018:

• the following CGUs have been separated out for test purposes:
  – KWK Budryk Mine,
  – KWK Knurów-Szczygłowice Mine: Knurów Section, Szczygłowice Section – due to technological and economic links between these two sections,
  – KWK Pniówek Mine,
  – KWK Borynia-Zofiówka-Jastrzębie Mine, Zofiówka Section,
  – KWK Borynia-Zofiówka-Jastrzębie Mine, Borynia Section,

• life of individual JSW plants:
  – KWK Budryk Mine – until 31 December 2077,
  – KWK Knurów-Szczygłowice Mine – until 31 December 2078,
  – KWK Pniówek Mine – until 31 December 2051,
  – KWK Borynia-Zofiówka-Jastrzębie Mine, Zofiówka Section – until 31 December 2051,
  – KWK Borynia-Zofiówka-Jastrzębie Mine, Borynia Section – until 31 December 2042,

• coal price forecasts for the years 2019-2023 based on the CRU report,
• as regards investment activity in 2019-2023, they include projects whose execution with the use of external financing is planned,
• the impairment analysis was determined on the basis of the latest economic data prepared in real terms and using the average weighted average cost of capital (discount rate) in the projection period at a level of 8.09% (9.99% before tax),
• financing of expenditures for decommissioning mines from the Mine Closure Fund (FLZG),
• inclusion of the existing provisions for employee benefits and other provisions ascribed to the given mine to determine the value of the tested assets,
• the impairment losses of PLN 1,266.8 million for property, plant and equipment and intangible assets at the Budryk Mine and of PLN 1,584.8 million for the Knurów-Szczygłowice Coal Mine recognized by 31 December 2017 have been included.
• takes into account the scientific and research analyses conducted in 2017 and 2018 by AGH University of Science and Technology in Krakow concerning the quality of coal samples acquired from the works opening new deposits at the Budryk Coal Mine included in the report entitled “Development an effective production structure model, including the share of coking coal at the JSW S.A. Budryk Coal Mine in 2021-2030”,
• The “Financial Model for 2019-2023 prepared for the purposes of the asset impairment test” takes into account the Management Board’s decision to shut down in the long term the mining of parcel H at the Zofiówka Coal Mine resulting from a non-recurring event (high-energy shock wave). The decision made by the Management Board was preceded by an opinion of the State Mining Authority on the possibility of recommencing mining operations and the risk of such operations in the vicinity of the shock area.
• included development of a new unit, “KWK Bzie-Dębina under construction” as development capital expenditures not included in the Zofiówka Section CGU, to achieve its full production capacity after the projection period, i.e. after 2023 and for which no asset impairment test has been carried out.

As a result of the calculations, as at 31 December 2018, the following recoverable value constituting the value in use of the cash generating centers for individual mine units were determined at the following level:

The tests performed have shown the expediency of recognizing impairment losses of PLN 303.1 million for property, plant and equipment and intangible assets at the Knurów-Szczygłowice Coal Mine and of PLN 910.9 million at the Zofiówka Section of the Borynia-Zofiówka-Jastrzębie Coal Mine as at 31 December 2018.

By taking into account the scientific and research analyses conducted in 2017 and 2018 by AGH University of Science and Technology in Krakow concerning the quality of coal samples acquired from the works opening new deposits at the Budryk Coal Mine included in the report entitled “Development an effective production structure model, including the share of coking coal at the JSW S.A. Budryk Coal Mine in 2021-2030”, the impairment loss for property, plant and equipment and intangible assets of the Budryk Coal Mine in the amount of PLN 719.1 million has been reversed.

The total impairment loss made as a result of the impairment tests carried out on the non-current assets of JSW’s units in 2018 recognized in 2018 amounts to PLN 1,214.0 million (PLN 1,213.1 million of that figure pertains to property, plant and equipment while PLN 0.9 million pertains to intangible assets). The charge is related to the Coal segment and has been recognized in other costs in the consolidated statement of profit or loss and other comprehensive income.

The total impairment loss reversed as a result of the impairment tests carried out in 2018 on the non-current assets of the Budryk Coal Mine amounts to PLN 719.1 million (PLN 719.0 million of that figure pertains to property, plant and equipment while PLN 0.1 million pertains to intangible assets) was recognized as other revenue in the consolidated statement of profit or loss and other comprehensive income in the Coal segment.

The results of the sensitivity analysis carried out for individual cash generating units have shown that the biggest impact on the value in use of the tested assets was caused primarily by changes in coal prices, changes in the average weighted cost of capital and changes in the production level.

Presented below are estimated changes in the impairment loss of non-current assets as at 31 December 2018 as a result of the most important changes for the units generating positive cash flows during the forecast period:

KWK Budryk

KWK Knurów-Szczygłowice