by Bob Dickerman
Perceptions of cost savings, economies of scale in generation and transmission, and opportunities to optimize executive compensation for the buyer are just some of the reasons that drive the desire to merge U.S. investor-owned utilities. If these are attractive acquisition targets to U.S. utilities and financial investors, then wouldn’t they also be attractive to foreign-based utilities?
Couldn’t international utilities that understand the economic model benefit from the same synergies?
Since the U.S. is the world’s largest market for all energy products, wouldn’t buying a U.S. utility be an excellent way for a foreign utility to gain access to this market and learn the regulatory ropes?
The short answer to all of these questions is “Yes,” particularly for European large-cap utilities.
At core, long-term reliable cash flows generated by U.S. utilities make them extremely attractive targets for any global company with a conservative to moderate risk profile that desires access to the U.S. market.
This is not a new concept, but we may be on the cusp of a growth spurt for reasons of strategy, structure and timing. We should expect to see significant growth in foreign-based acquisitions of U.S. utilities and other businesses that fit the cash flow and risk profile of utilities, but are subject to less restrictive regulation.
European utility M&A surpasses U.S. activity
Over the past decade, few trends have been as widely predicted as utility mergers and consolidation of the U.S. electric and gas market. Common wisdom holds that, although the system was designed to be a collection of regionally independent vertical monopolies, the result is economic inefficiency and regulatory confusion. As a consequence, we have lived for decades with a highly fragmented system of regional utilities, poor interconnection capability, complex, inconsistent regulation and minimal governing federal energy policy.
With the repeal of the Public Utility Holding Company Act restrictions in the Energy Policy Act of 2005, multi-regional mergers are now allowed and speculation is rampant that we will soon see an explosion in mergers of like firms across the country.
Recent mergers in U.S utilties have been driven by balance sheet economies of scale, cost synergies, increasing capital and credit needs, PUHCA repeal and executive compensation. Environmental regulations such as the Clean Air Interstate Rule and Clean Air Mercury Rule will require larger entities to cover the costs of compliance, which could become prohibitive for all but the largest entities. New investment needed for transmission upgrades and generation, especially new nuclear generation, will also fuel this move toward larger utilities.
In the past 10 years some notable mergers, like Exelon-Peco and Duke-Cinergy, have successfully closed and local public utility commissions are getting comfortable with the idea of having financial investors as owners-Berkshire Hathaway or Kohlberg Kravis Roberts & Co. and Texas Pacific Group, for instance.
But there have also been some spectacular merger failures-Entergy-FPL, FPL-Constellation, Exelon-PSEG-during the same period. In some cases, executive control issues or due diligence surprises ended deals prematurely. In other cases, mandated rate givebacks, wholesale fuel price spikes and market power issues contributed to the demise of pending mergers.
One key point to remember, however, is that in general, utilities have not failed to merge because the businesses weren’t attractive or were overvalued. In fact, perhaps due to merger expectations or because analysts are better understanding the true value of these enterprises, P/E multiples of investor-owned utilities have surged across the entire industry.
What some observers fail to notice is that during the same 10-year span, European utility merger and acquisition and mass has surpassed U.S. activity by almost any measure. In fact, European utility consolidation is far ahead of the U.S. by several measures.
The enterprise value of the merged companies is larger than those in the U.S. Pending current mergers, E.ON, àƒâ€°lectricitàƒ© de France (EDF) and Gaz de France (GDF) will have market caps of U.S. $120 billion to $180 billion, compared with the three largest U.S. utilities, Exelon, Dominion and Duke, none of which exceeds $60 billion even after recent mergers. In fact as a group, European utilities trade at higher P/E multiples than their U.S. counterparts, reducing the relative cost of capital for stock purchases by European firms.
In addition, European countries have federal regulations and national energy policies that dominate regional or local issues. EU regulations are driving consistency across member countries in retail direct access, divestiture of generation, open access to transmission and access to capital. These rules are far from perfect, and in quite public cases are running into national protectionist resistance. Domestic protections from external takeovers do not translate into shyness about reaching beyond national borders for acquisitions.
European utility investments: Why not more?
The recent announcement that Iberdrola will acquire Energy East is just one of a series of investments that include the LG&E, KeySpan, New England Electric System and PacifiCorp deals. (PacifiCorp’s European owner, ScottishPower, subsequently sold the utility to MidAmerican Energy Holdings Co.) Other multinationals have gone after Duquesne Light and numerous generation holding companies such as Sithe Energy.
While none of the European purchases of U.S. utilities has come close to the size of oil acquisitions such as BP’s purchases of Amoco and Arco in the late 1990s, that doesn’t mean there isn’t a lot of interest. Surveys of European utility heads show that more than 60 percent admit that they are actively seeking acquisitions in the U.S., driven by a desire for access to the U.S. market, greater market share and economies of scale.
One interesting question is why we haven’t seen more merger attempts from Europe, given the size and access to capital of many of these behemoths. One might suspect that the weakening dollar relative to the Euro and other currencies might have prevented some deals over this period, but that theory doesn’t prove out in surveys of potential buyers.
A far more likely explanation is that U.S. utility regulations seem very confusing and complex to outsiders. Some international companies with a high degree of sophistication still have trouble grasping the fact that the U.S. market is moving in two conflicting directions-and rapidly. With widely conflicting sentiments across state public utility commissions, outside observers have seen this conflict manifest in deregulation policy and wide pendulum swings between pro-competition policy in some states at times followed by opposing policy at the same time in other states or a nearly complete reversal in policy within three years.
Confusion reigns for the outside observer concerning policy such as ownership of generation, regional FERC battles about the structure and rules governing capacity and reliability, and access to regional transmission. They watch with puzzlement when trading markets and the prototypical energy villain, Enron, is blamed for today’s natural gas prices when they well understand that the fundamentals of supply and demand are the only drivers.
Perhaps most telling, they are looking for signals or in the best case, a consensus, from state PUCs that on the one hand refuse the acquisition of Tucson Electric by financial investors and shortly afterward approve a $45 billion acquisition of TXU by some of the same investors.
This confusion has prevented more deals from being proposed than we will ever be able to measure or verify, but the market view from Europe may be shifting and the perceived barriers may be coming down. For one reason, foreign acquisition attempts have been going more smoothly over the past 18 to 24 months than previous negative headline events. There also seems to be a stronger consensus than before that U.S. utilities, representing monopoly service in a robust economy, are excellent values and can become a platform for further U.S. market expansion in regulated or unregulated areas. In fact, this exact strategy has been stated as the core rationale for some recent utility acquisition announcements.
Trends and transformation
When we look in the rear view mirror five years from now, we may find that the TXU change in ownership, while not merging multiple businesses, is transformational in terms of the way the foreign market views U.S. opportunities. The conceptual argument is that if a financial investor can unlock value after paying market prices or a small premium, then certainly others outside the U.S. can replicate the private equity game, and a buyer’s experience with managing public utility regulations can only increase the return on capital invested. Finally, just as every hammer seeks a nail, the vast sums of capital controlled by the few desperately seek homes, and any large, relatively safe market in the U.S. will naturally attract investment attention.
Unlike death and taxes, it has always been difficult to predict large trends in U.S. energy markets, much less global markets. That said, the driving influences of future utility mergers and foreign investment are likely to be:
- actual savings generated by U.S. mergers and realized by shareholders
- return on investment created through private equity buyouts such as TXU
- success non-U.S. companies have in practice with U.S. regulations
We should never expect utility investments to yield the highest possible returns or be able to compare them with more risky businesses such as merchant generation or speculative energy trading, but as a group they are likely to become a type of investment that attracts a great deal of new investment domestically and overseas to unlock enormous value as a group for new investors and existing shareholders.
More opportunities, including LNG and carbon markets
Aside from buying a fully regulated electric or gas utility, there are other less regulated energy investments in the U.S. that are attracting attention and significant deals are starting to be done.
What these investments seem to have in common is that they are asset-based, offer reliable cash flows from long-term contracts, have little earnings volatility or downside potential, and leverage operational energy knowledge and capabilities. These investments include LNG receiving terminals, non-marine natural gas storage, natural gas pipelines and midstream companies for processing oil or natural gas.
Of these, LNG is the newest market opportunity. As the emerging global trade for gas creates new assets and a tradeable global commodity, some players are lining up on the demand side with regasification terminals, new downstream pipelines and establishment of gas marketing companies to market the fuel to electric utilities, merchant plants and industrials. LNG investment in the U.S. may not have the long-term cash flow profile that a full EDC or LDC has, but it has the potential for higher returns and allows the acquirer to become familiar with the U.S. market players, regulations and economics. Some LNG strategies today are filling out a global supply chain that includes gas production, gasification, shipping and marketing. Others are pointedly opportunistic, seeking that market niche where gas prices are volatile, access to domestic gas is limited and competitive plants are not too far ahead in the siting/planning process.
Renewables and carbon markets are obviously another platform for growth in the U.S. sector, and again it is clear that European utilities are ahead of their American brethren. We know that EDF already has 25,000 MW of renewable generation capacity-almost 20 percent of their capacity, far ahead of any U.S. firm. Enel has announced that it plans to produce 30 percent of its power from renewable sources by 2010. Compare this with our patchwork renewable portfolio standards put into place state by state and their progress to date. Carbon capture and CO2-free fossil plants are considered tomorrow’s technology in both markets.
These examples make it more likely, not less, that European firms will leverage their knowledge and technology in the renewables and carbon markets to invest in U.S. companies, start new ones and work very aggressively to catch the wave of private and public policy that mandates renewable portfolio standards and opens new carbon markets such as California and RGGI in the East.
Renewables and carbon markets are obviously another platform for growth in the U.S. sector, and again it is clear that European utilities are ahead of their American brethren. Click here to enlarge image
If there is one prediction we can make safely, it is that we will see dramatic change, and further, that the pace of change will accelerate. Companies that can identify trends quickly, are well capitalized and can act quickly will get to write the rules and become the ultimate economic victors.
Bob Dickerman is a managing director in the energy practice at Navigant Consulting Inc. He is active in strategic issues involving utilities and other energy businesses globally. Navigant is a publicly traded consultancy that offers industry solutions and insights across multiple industries. Contact Bob at email@example.com.
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