Business & Money

Can economies of scale make the industry more stable?

The recent Northeast Blackout framed for regulators and public policy-makers one of the central issues confronting the utility industry: infrastructure reliability and the significant capital investment requirements necessary for improvement. While estimates vary widely, some industry experts currently project that the investment necessary to revitalize and secure the transmission infrastructure in the United States may run in excess of $100 billion. The challenge for policy-makers in addressing these significant investment needs will be to create a sustainable economic and regulatory regime that is supportive of infrastructure investment while not unduly burdening either utilities or ratepayers.

The challenge is made more complex when one takes into account the already existing pressures on rates, especially from natural gas prices. Moreover, many utilities have not realized rate increases for some time, with current rate levels also frequently funded by cost savings strategies that are not sustainable over the long term.

The good news is that a solution is readily available that would properly balance these structural and economic imperatives: create a comprehensive regulatory environment supportive of utility consolidation that directs a significant portion of the derived merger synergies toward infrastructure investment.

The North American utility industry remains highly fragmented, in part as a consequence of a regulatory environment that is adverse to consolidation. For example, current state regulatory practices typically result in 50 percent or more of merger-related cost savings being passed on to ratepayers in the form of rate cuts. This inability to capture the economic benefits of mergers, coupled with onerous and extraordinarily time-consuming regulatory approval processes, has significantly impeded merger activity in the industry. As a result, the consolidation that occurred in most industries over the past two decades, and that resulted in significant respective economies of scale, largely bypassed the utility industry.

Utility mergers create exceptional efficiencies, yielding average cost savings of approximately 5 to 10 percent of the combined company's non-fuel operating expenses. These substantial untapped cost efficiencies could be harvested through more merger-friendly state regulatory policies that would enable utilities to retain these merger cost savings so long as a significant portion was channeled toward infrastructure investment. Provided that utilities would be allowed to earn timely, economic returns on such investments, this would provide a powerful inducement for consolidation and generate enormous investment capital. For example, if 50 percent of merger synergies were directed to investment in the U.S. electricity system and the top 100 utilities merged to create only 50, it could result in as much as $50 billion in derived cost efficiencies being allocated toward electricity system investment.

As a result of the earnings-growth challenges facing the industry (see Figure 1) at a time of historically high trading multiples (see Figure 2) and significant exposure to interest rate increases (see Figure 3), the utility industry could be quite inclined to pursue consolidation, assuming reasonable regulatory support exists. Consolidation remains a viable means to generate earnings growth and value, as compared with other methods that have been pursued in the past (e.g., international, non-utility businesses, large