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Electric M&A: A Regulators Guide

Fortnightly Magazine - January 1 1996

its shareholders.

Any evaluation of merger-related savings must consider the direct costs of the merger as well. These direct costs typically consist of transaction costs, transition costs (costs associated with early retirement options, severance pay, and other labor-reducing costs), and the acquisition premium. In most circumstances, the acquisition premium will comprise the lion's share of the total direct cost for any one company to acquire another. An acquisition premium exists when the purchase price of the acquired utility exceeds book value. Thus, one of a regulator's first steps should be to ensure that proposed merger savings exceed the acquisition premium. In recent mergers, the regulatory treatment of the acquisition premium has varied, ranging from full to no recovery. Most PUCs, however, have struck a middle ground and allowed utilities to recover the cost of the acquisition premium from the savings that result (em any excess savings are then passed on to customers.

Financial Integrity

Financial integrity carries long-term implications. A historic and projected financial analysis of merging companies should be performed on both a stand-alone and combined basis. Financial factors to examine include: capital structure ratios, bond ratings, cost of debt, preferred stock and common equity, cash flow, interest coverage ratios, dividend payout ratios, and the financial community's response to the proposed merger. Other related factors that influence the overall financial strength and risk of the individual and combined companies include customer mix, generation mix, customer growth potential, and geographic diversity.

A common merger involves the acquisition of a financially weak company by a stronger, healthier neighboring utility. While the merger generally would benefit the weaker company's customers and shareholders, the opposite might be true for the stronger company. In that case, one method of reducing adverse rate impacts to the stronger company's customers is to set rates on a stand-alone basis (e.g., based upon the capital structure and costs of the stronger company alone). Another possible method is to attempt to quantify the additional cost to ratepayers from the weakened financial condition of the stronger utility and to classify it as a direct cost of the merger that could be borne entirely by shareholders (em or shared between ratepayers and shareholders. Occasionally, however, mergers between weak and strong companies may not have an adverse impact on ratepayers. This situation can arise from the difference in capital structures, which can produce a lower overall cost of capital for the stronger company, resulting in lower rates for all customers.

Quality of Service

In keeping with the public interest standard, regulators must evaluate the effects of a merger on the quality of service provided to customers. This would include reviewing the customer service records of both companies, proposed customer service office consolidations and/or eliminations, merger-related changes to reliability, and maintenance programs. In addition, PUCs should ensure that their own actions do not threaten service quality (em for example, allowing maintenance to be deferred if projected merger savings fail to materialize. While regulators may discover some minor short-run problems, mergers should not have any long-run negative impacts on quality of service.

Regulatory Complexities

Mergers often