Dynegy-Illinova deal signals re-integration

Gerald Keenan

PricewaterhouseCoopers

The continuing flurry of merger and acquisition activity has brought a variety of new participants into the traditional electric utility business. Much attention has been given to the pending acquisitions by foreign utility companies. Just as interesting, but less explored, is the movement of independent power producers (IPP) and integrated energy marketers downstream into the still regulated portions of the electric industry.

Is this the beginning of a trend? Or are these simply isolated acquisitions? A closer look indicates these are probably the leading edge of a re-aggregation trend, which will have significant implications for the electric business.

Beginning with Enron`s 1997 acquisition of PGE Corp., parent of Portland General Electric, the past year has seen three new examples of IPPs or integrated markets move downstream to acquire electric utility companies.

– In March 1999, independent power producer CalEnergy completed the acquisition of

– owa-based utility MidAmerican Energy Holdings. This was the first acquisition of an electric utility by an IPP in the United States. (CalEnergy already owns Northern Electric, a regional electricity company in the United Kingdom, acquired in 1996).

– In November 1998, leading global IPP firm AES Corp. of Arlington, Va., announced the acquisition of CILCORP, a modest-sized combination gas and electric utility in

– llinois, where retail markets will begin to open in October 1999. More recently, AES announced the acquisition of New Energy Ventures, one of the country`s leading energy retailers.

– In June 1999 top-tier gas and electricity marketer Dynegy announced the acquisition of Illinois-based Illinova. This relatively complex transaction will result in Chevron, a major integrated oil company, as the major owner of the new firm, with an approximately 29 percent share interest, to be followed by additional investments in the firm. (See sidebar).

New entrants

Previous utility mergers and acquisitions usually involved neighboring operating companies. These mergers were driven largely by the desire to cut costs, exploit synergies (for example, via consolidated dispatching and fuel purchasing), and create the large enterprises required to compete in deregulated markets. Unlike the transactions mentioned above, these mergers maintained the traditional regulated industry structure and did not fundamentally change the nature of the companies involved.

What characterizes these new players? First, and most important, is their experience in competitive deregulated markets, which require entirely different skills, culture and outlook than traditional regulated utilities.

Second, they are growing rapidly in businesses that have significant risks-power plant development, wholesale energy marketing and trading, and international power markets. Third, they are all developing portfolios of assets and businesses across the new energy value chain (see figure). In short, we are seeing the beginning of the re-integration of the electric industry-even as the de-integration (selling of generation assets, etc.) continues.

Merger drivers

Most deregulated commodity industries (oil and gas, grains, etc.) are characterized by a significant degree of vertical integration throughout the value chain. Until recently, upstream players in the electric industry, including IPPs and oil and gas majors, have not participated in the regulated downstream market segments. In part, they were avoiding webs of federal and state regulation.

Regulators` generally positive response to these first transactions, however, is likely to encourage more upstream players to look seriously at downstream assets and businesses. Additionally, with more than half of the country`s retail electric customers accessible to marketers by 2003, the attraction of downstream markets will continue growing.

The movement into regulated utilities is driven by a combination of operating, market, regulatory and financial factors.

– Forward integration: As electric and natural gas markets continue to deregulate, the value of upstream assets and skills (multi-Btu energy trading, marketing and risk management) can be enhanced in downstream markets. Integrating downstream markets (generation and retail gas and electric supply) with upstream assets (fuel supply and transport) and capabilities (trading and risk management) can increase asset utilization and reduce risks in both markets. Portfolio management skills and experience in operating generating plants in deregulated markets are also expected to create value in the acquired companies.

– Investments in “hot” markets: With the accelerating pace of deregulation in the United States, many energy market participants see the North American market as providing better opportunities than most foreign markets/. Many generators targeted the Midwest following 1998`s price spikes. Acquiring existing assets may provide a fast entry into this market. Also, Illinois is expected to become the first Midwest state to deregulate its retail electric markets, with competition beginning for industrial and many commercial customers in October 1999.

– Light-handed regulation: Two of the three acquisitions are Illinois-based. Illinois` industry reform legislation eliminated the requirement for often extended and contentious regulatory approvals. Additionally, the legislation provides a price-cap regime until 2004, reducing regulatory uncertainty and permitting acquirers to keep the value of cost cutting and synergies.

Other legislative provisions reduce regulatory control over asset sales and other forms of corporate rationalization. Speedy approval has also been gained at FERC. Because the acquiring firms have no market power in the Midwest, concerns about diminution of competition are eliminated.

– Steadier earnings and cash flows: For years, investors have valued the steady cash flows which result from regulated utilities. Experience in the deregulated U.K. electric market shows the majority of earnings and cash flow come from regulated wires businesses. As noted above, all the new entrants have ambitious growth targets. The steady cash flow and earnings of this still-regulated business provide balance for riskier upstream businesses.

With the completion of the mergers, roughly 25 percent of Dynegy`s and AES` near-term earnings (and more than half of CalEnergy`s earnings) will come from regulated operations. This can improve credit ratings, as it did for CalEnergy. Other significant market players-such as Southern Co., PG&E and Edison International-already enjoy the benefits of steady cash generators in their corporate families.

Brave new world

The MidAmerican, CILCORP and Illinova transactions combine regulated utilities in slow-growth local franchises with larger energy portfolios in a high-growth, global market. To meet ambitious earnings and cash flow targets, new owners will likely drive efficiencies, increase revenues, and seek to transform acquired companies into significant competitors in their markets. Such changes will undoubtedly affect neighboring utilities, driving further mergers, acquisitions and cost cutting.

These first acquisitions are likely to encourage other upstream market participants, including major oil and gas companies, to invest in the downstream portions of the market. Chevron`s ownership in the combined Dynegy/Illinova and Shell`s participation in retail gas and electric marketing in New York and Georgia are the first, small steps of a significant movement by major fuel suppliers into the generation and retail energy markets. Eliminating ownership barriers, such as the Public Utility Holding Company Act (PUHCA), will accelerate this trend.

Investors will also see accelerating changes as electric utility stocks evolve from income to growth stocks. AES and CalEnergy will likely continue to pay no dividend, in contrast to pre-acquisition CILCORP`s $2.46 per share and MidAmerican`s $1.20. Dynegy will pay $0.60 per share, less than half Illinova`s $1.24 dividend.

Almost overnight, these local regulated utilities become largely unregulated energy providers serving a global market. For these companies and their shareholders, their acquisitions are transformational transactions. n

Gerald Keenan is the lead partner with PricewaterhouseCoopers Energy/Utilities Strategy Consulting practice in Chicago. Assistance in writing this story was provided by PricewaterhouseCoopers Manager Mark Ciolek and Associate Michael Langman.

Click here to enlarge image

Electric utility market entries by upstream energy companies demonstrate a transformation in the energy value chain. Financial trading markets link fuel and electricity commodities along wholesale segments.

DYNEGY, CHEVRON, ILLINOVA IN THREE-WAY TANGO

Dynegy has been owned primarily by three large industrial shareholders – Chevron (29 percent), BG Plc (parent of British Gas, 24 percent) and Nova Chemicals (24 percent). After Dynegy`s planned merger with Illinova, Chevron plans to maintain its stake by investing an additional $200 million to $240 million. Nova and BG will receive cash for their ownership, but each will continue to maintain an approximately 5 percent interest.

The merger of Illinova and Dynegy was approved by both companies` boards of directors, but it still requires state and federal regulatory approvals. The combination creates a full-service energy company with annual revenues of about $17 billion and a market capitalization of $7.5 billion.

In addition to needing regulatory approval, the merger is contingent upon the sale of Illinova`s Clinton nuclear plant. The plant is expected to be sold to AmerGen Energy Co., PECO`s joint venture with British Energy Plc.

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The Clarion Energy Content Team is made up of editors from various publications, including POWERGRID International, Power Engineering, Renewable Energy World, Hydro Review, Smart Energy International, and Power Engineering International. Contact the content lead for this publication at Jennifer.Runyon@ClarionEvents.com.

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