21st century basics: hunting earnings in mergers & acquisitions

When last I penned this column, I addressed “back to basics,” or B2B. Many investor-owned electric utilities retrenched to B2B to rebuild from the rubble of the 2000/2001 Western energy debacles and the collapses of Enron and other energy merchants. In that column I asked how those B2B utilities would achieve sufficient earnings growth now that long-dormant interest rates have begun a steady ascent. One answer was through mergers or acquisitions.

Exelon’s stock acquisition of PSEG had only then become a case in point. But quick on its heels came other big plays: Duke and Cinergy have committed to marry their fortunes in another exchange of stock; MidAmerican stands poised to buy PacifiCorp from ScottishPower. While providing an avenue for earnings growth, will these combinations concentrate market power to an extent inconsistent with evolving forms of market-based regulation? And if these proposed consolidations successfully navigate a sea of challenges, will they then presage a uniquely 21st century pursuit of earnings growth through scale economies or a return to the vilified power trusts of 1920s’ yore?

Concurrently with the announcements of these consolidations, a Securities and Exchange Commission judge cast into doubt the viability of growth strategies anchored in utility mergers and acquisitions. In a May 3 order, the judge ruled that the Commission was mistaken six years earlier when it condoned another consolidation, American Electric Power’s acquisition through merger of Central & Southwest, as satisfying the “integrated public-utility system” demand of the Public Utility Holding Company Act of 1935 (PUHCA). Like an appeals court before him, the judge concluded that, notwithstanding AEP’s purchase of transmission interconnecting with CSW over several hundred miles of separation, the two systems were not in a single area or region as PUHCA requires.

AEP has appealed the judge’s decision to the SEC, which may yet reconcile this merger with the New Deal-era statute. Moreover, Congress could intervene: Both houses of the 109th Congress continue to play their now familiar roles in passing PUHCA repeal bills, which, if enacted, could rescue the AEP acquisition of CSW and pave the way for Exelon, Duke and MidAmerican.

Scale economies and cost savings appear to be the drivers of both the Exelon and Duke combinations. For its part, the Exelon-PSEG merger combines known strengths that overcome perceived weaknesses in each company. On the positive side of the ledger, the new company would combine Exelon’s track record of low-cost nuclear operations with PSEG’s strong performance in transmission and distribution operations. Exelon projects that this marriage will reduce operating costs through workforce cuts and scale economies.

Similarly, the expanded Duke will try to capitalize on combining Duke’s Midwestern natural gas-fired merchant generation with Cinergy’s older and predominantly coal-fired regulated and merchant fleets, providing both supply and demand flexibility and an opportunity for Cinergy to modernize its generation base and reduce greenhouse gas emissions. These combined operations will allow the expanded Duke to pursue earnings growth through savings, trimming the combined work force by an estimated 1,500 employees.

The Duke-Cinergy combination also carries with it a B2B commitment. At both utilities, management has suggested that the Cinergy acquisition may be the first step in a transition that ultimately will see the natural gas operations of the combined companies separated and spun off from electric power operations. The end product would be one large, yet very basic, power company and a separate and equally basic natural gas company.

MidAmerican’s PacifiCorp purchase appears to blaze a different trail. Neither MidAmerican nor its majority-owner Berkshire Hathaway lays claim to synergistic business drivers. Nor do they foresee significant cost savings through workforce reductions or other cost cutting. Rather, the driver of this acquisition appears to be long-term market positioning. PacifiCorp’s utility operations in Oregon and Utah will provide MidAmerican with access to the Northwest, Southwest and California power markets, the last of which is growing at a 4 percent annual rate. MidAmerican’s acquisition appears to be more about earnings growth through market positioning as opposed to earnings growth through specific scale economies and targeted cost reductions.

Horizontal combinations, such as the Exelon, Duke and MidAmerican transactions, eliminate competition between the merging firms. This is of little consequence where the merging firms are small or are in businesses characterized by easy entry and exit. But natural gas and electric public utilities are neither small nor susceptible to particularly easy entry or exit. Competition eliminated through mergers and acquisitions between utilities typically is controversial because the combined utilities have the potential to concentrate market power and, in the case of holding company utilities, induce affiliate and reciprocal dealings at inflated prices harmful to ratepayers.

For this reason, federal and state law enforcement officers, consumer advocates and competitors are scrutinizing the Exelon, Duke and MidAmerican transactions to ascertain whether, under the antitrust laws, these consolidations lessen competition or tend to create a monopoly. They will also be reviewed for consistency with the public interest-whether the anticipated benefits and savings of a combination outweigh the threat to competition-as well as consistency with the applicants’ authority to continue making wholesale power sales at market (rather than cost-of-service) prices. Any one of the announced deals could also run aground on the shoals of PUHCA’s “single public-utility system” requirement as interpreted in the May 3 order, provided that legislation repealing the Act is not enacted.

Exelon has placed a premium on expediting its PSEG acquisition. That will turn on averting an evidentiary hearing before FERC to determine whether the transaction is consistent with the public interest. To pacify regulators and other opponents, the merging companies have proposed increasing their initial proposal to divest outright 2,900 megawatts of fossil generation by an additional 1,100 megawatts and contracting out an additional 2,600 megawatts of mostly nuclear capacity on a long-term basis.

This gambit appears to have succeeded, at least thus far. Over the opposition of fellow PJM Interconnection members, the American Antitrust Institute, and a number of ratepayer advocates, on July 1 FERC approved the PSEG acquisition, without convening a hearing. As a consequence, Exelon remains on track to close its acquisition in the first quarter of 2006. In contrast to Exelon, Duke and MidAmerican appear to be reconciled to the likelihood that hearings will be convened to explore the consistency of their acquisitions with competition and the public interest.

Mergers and acquisitions that survive antitrust review and a FERC public-interest hearing will still need to address market-power concerns. If not obviated, those concerns could jeopardize the applicants’ FERC-conferred market pricing authority, which is widely perceived as essential for competing in today’s wholesale power markets. In 2004, FERC adopted two “screens”-a measure of wholesale market share and a test to determine whether a supplier is “pivotal”-through which it filters indicators of market power. As confirmed in recent analyses applying these screens, many if not most of the six merging utilities own or control percentages of available generating capacity within their control areas that raise market power concerns under one or both screens, even before they are combined with their merger partners. Because of its failure to pass the screen that measures wholesale market share within its control area, Duke was recently ordered to discontinue market pricing of its wholesales sales within that control area.

To the extent that their merger partners operate in the same or adjacent wholesale power markets or control areas, their combinations will increase the combined company’s share of the wholesale power market and potentially increase the extent to which it serves as a pivotal supplier. Either eventuality would require that market power be mitigated-probably in the form of generation divestiture or long-term contracting out generation à la Exelon-PSEG-as a prerequisite to the new company being allowed to retain market-pricing authority. If the merger partners are not geographically proximate, then, within their respective markets or control areas, their combination would neither concentrate market share nor magnify the combined company’s role as a pivotal supplier.

While this eventuality would not raise concerns of concentrated market power, it ironically could make it more likely that the merger would run afoul of PUHCA’s “single public-utility system” requirement as that requirement was interpreted by the SEC administrative judge in the AEP case. According to that judge, PUHCA requires that the combined public utility system be confined to a single “geographic” area or region. In light of that construction, several industry observers have surmised that both the Duke and MidAmerican acquisitions are, in reality, craps table come bets that the 109th Congress will, unlike so many of its predecessors, finally repeal PUHCA.

Yet one more hurdle may confront those pursuing earnings growth through a merger or acquisition. In the AEP case, FERC conditioned its public interest authorization of the merger on the combined utility’s surrendering operational control of its transmission systems to an independent regional transmission organization. This was necessary, in FERC’s view, to mitigate the transmission market power of the combined utilities. FERC should be expected to attach a similar condition to the merger applicants currently before it. That did not prevent FERC from authorizing Exelon’s acquisition of PSEG since both are members of the PJM Interconnection. Nor should such a condition deter MidAmerican, which itself is a member of the Midwest ISO and has endorsed membership in a similar independent operation for the Western markets in which PacifiCorp owns transmission. But for Duke, surrender of transmission system operating control may prove a poison pill; the North Carolina utility-together with other Southeastern transmission system owners and regulators-has steadfastly refused to participate in an independent operator or to surrender any transmission system control.

The hurdles confronting each of the announced combinations beg the question, what if the merger or acquisition fails in the near term? How will earnings growth be achieved? For some utilities, that growth will default to more B2B investments in an expanded rate base of big-ticket hardware: new transmission, IGCC generation technologies and possibly a nuclear development renaissance. Alternatively, some may suspend M&A growth strategies and return to diversification into non-regulated and possibly even foreign operations.

Conversely, if the pending mergers succeed and usher in others, with or without PUHCA repeal, what will that portend? Will market power become so concentrated that regulators are forced to reconsider their still young affair with market pricing? The answer to that question will turn on the mitigation conditions imposed on combining firms. Additionally, we need to ask whether a rash of consolidations will herald the return of power trusts, as some fear. While that should be a concern, a return of the power trusts is unlikely. Proposed consolidations will expand the size and reduce the number of utilities. Quite possibly they also will increase market power and reduce competition in certain utility services.

But a return to the impenetrable financial structures of the 1920s’ power trusts should be prevented by enforcement of PUHCA’s financial simplification requirements, as well as the financial disclosure and verification requirements of the 1933 and 1934 securities laws and Sarbanes-Oxley. Even in the increasingly likely event that PUHCA is repealed, then under the most-tenable scenario of the comprehensive energy bill to emerge from a Senate-House conference committee, new FERC-enforced transparency and disclosure rules will be enacted, which (together with the securities and Sarbanes-Oxley laws) should be sufficient to protect against the holding company shell games of the 1920s as well as the accounting shams of certain 1990s energy merchants.

Dan Watkiss (Dan.Watkiss@bracewellgiuliani.com) is a partner with Bracewell & Giuliani in Washington, D.C.

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