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Vertical Integration: Necessity or Distraction?

An analysis of the latest wave of unbundling, re-bundling, and convergence plays in the gas-power industries.
Fortnightly Magazine - April 15 2002


Indicator 2

Will gas supply enhancements arrive without eroding market efficiency?



Depends on the form the new supply takes. On the one hand, LNG terminals are economically viable at relatively small scale and close to critical markets. An end state in which numerous and scattered LNG terminals import 2-4 Tcf per year portends a vibrant and efficient natural gas market, thus favoring the "Market and Focus" scenario. Alternatively, a market solely dependent on the Arctic for supply enhancement places its future in the hands of policy makers and a small number of consortia willing to fund these enormous infrastructural undertakings, who may again face the issue of bottlenecks in take-away capacity from Alberta.

Indicator 3

Will power market stability and depth improve? Even with recently announced reversals of capacity addition plans, the U.S. generation market appears to be on the verge of a period of excess supply in the coming years. In addition, many of the least efficient peaker units are exiting the market. As a result, generation price levels and volatility are likely to decrease in coming years, setting aside the wild card of natural gas prices discussed above.



Favors "Market and Focus" scenario. If combined with improved wholesale market architecture and transmission capacity markets, we can imagine an increased reliance on wholesale power markets, as retailers seek supply and generators have little alternative but to sell "excess generation" into spot markets.

Indicator 4

Will regulators lose faith in markets? Regulatory decisions have been the primary source for many of the changes we've witnessed in the gas and power sector over the past decade. As we've seen in California, the liberalization process can be stopped, at least for a time, and the ongoing controversies over transmission reform cast doubt on the prospects for improved market efficiency in the near term. Increased regulatory scrutiny of trading and derivatives may also retard the development of the wholesale markets, at least in the near term. The long-anticipated reform of PUHCA, with its promise of accelerated re-organization of the market, may also be placed under a shadow.



Would delay either scenario from emerging. Increased regulatory scrutiny of M&A activity and anxiety about market power would likely accompany a curtailment of the liberalization process. This would preclude either of the scenarios described above and would instead support maintaining the status quo of largely geographically defined, integrated utilities.

Indicator 5

Will new business models emerge?



Favors "Market and Focus" scenario. Capital efficiency and operational excellence are critical in the asset-intensive gas and power industries, and if there are substantial differences in these capabilities across firms, the drive for focused excellence will be a powerful counter to vertical integration. Pure-play specialists, with markedly superior capital and operating efficiencies, or superior logistical knowledge and positions in specific regions, are already beginning to emerge. This is especially clear in the upstream, where apart from the few integration-driven deals mentioned earlier, the overwhelming trend had been toward portfolio rationalizations and the emergence of sophisticated basin-specific players.

—D.G. & J.Q.


However, despite