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Watch the Cycle

Can the upward swing in global power infrastructure investment be sustained?

Fortnightly Magazine - February 2007

sizes doubled to nearly $500 million as national utilities attempted to merge into regional giants. Competition to provide financing for M&A transactions also has been very aggressive. Senior debt facilities arranged for major European acquisitions announced over the past year have seen banks scrambling to participate despite pricing in the range of 20 to 30 basis points above Euribor. Examples include the 32 billion facility for E.On’s bid for Endesa of Spain, and a 50 billion facility from local Italian banks for Enel in its bid to acquire French utility Suez.

The sheer size of these deals and the strong credit ratings of the bidders are allowing them to dictate terms to the eager lending community. Bankers ought to be feeling conflicted by the choice to participate in these blockbuster deals, though, at such thin margins.

European power companies generally are exposed less to potential cyclical volatility than their U.S. counterparts. The predominant business model remains one of vertical integration of generation, transmission, and distribution, and ownership of the sector is highly concentrated with a relatively small number of large national and regional utilities holding dominant market shares. Market liberalization, contrary to expectations, has not led to any significant entrance of startups. Concern over security of supply has pushed utilities to acquire upstream and midstream gas-supply assets, reducing the potential impact of exogenous shocks, and further consolidating the sector. These factors support increasing market power and earnings potential, which underpins current strong balance sheets and credit quality. Approximately 95 percent of rated utilities in the EU are ranked investment grade by major ratings agencies. Europe’s large utilities are able to finance construction largely with low-priced corporate loans based on their own balance-sheet strength.

North America

The past two years also have seen a sharp rise in the number and size of M&A transactions within the U.S. power sector. A number of multi-billion dollar transactions proposed in 2005 were finalized subsequently, and in 2006 there were more than 10 completed deals of greater than $500 million each, valued altogether at more than $17 billion. A key driver has been the repeal in early 2006 of the Public Utility Holding Company Act, which has reduced barriers to asset acquisitions and simplified approval processes. Given the industry size and the number of local and regional utilities, the outlook for continued consolidation remains strong. New plant construction also has been on the rise. Project financings valued at $6.4 billion were closed on 14 power plants during the first half of 2006, nearly double the previous year’s period. Merchant plants and hybrid short-term contracted plants are making a comeback due in part to the creativity of financial investors. And coal-fired plants are being considered once again due to the increase in natural-gas prices and a renewed policy push for U.S. energy independence.

The U.S. sector finds itself most exposed to the cyclicality of the industry relative to other regions of the world. Operating within a comparatively open, competitive, and increasingly deregulated market. In addition, the U.S. market remains more disaggregated than the European market.

The recent growth