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M&A Forecast

Will shifting winds bring consolidation?

Fortnightly Magazine - August 2010

A spate of deal announcements in early 2010 has the power and regulated utilities industry cautiously optimistic about a merger and acquisition (M&A) revival. Two of the largest deals include the proposed $9.27 billion acquisition of Allegheny Energy by FirstEnergy and PPL Corp.’s announced acquisition of the assets of E.ON US for $6.73 billion.

Although it’s difficult to conclude whether the recent activity indicates any lasting trends, a wave of industry consolidation might be building, especially if the recently announced deals reach the finish line. If those deals receive timely and satisfactory regulatory approvals, the industry should anticipate more M&A activity on the regulated side. Consolidation within the sector is attractive because of its potential to enhance growth, reduce costs, and boost stock values. When power and utility companies take advantage of economies of scale or serve a larger customer base, they have the opportunity also to operate more efficiently and perhaps more profitably, if the regulators allow them to retain reasonable synergy savings. Generally, the more scale there is, the stronger the balance sheet. Scale also could translate into enhanced credit ratings and cost synergies.

But if consolidation makes so much sense, why aren’t more deals being announced and finalized? The reasons are complex and are driven primarily by a combination of the following factors: the economy, regulation, legislation, access to capital and valuation, commodity prices, and the disposal of noncore assets.

M&A Drivers and Deterrents

Although the economy might be strengthening, at least in certain regions of the country, the recession sapped demand and undermined operating cash flow and capital expenditure plans for new generation facilities. Therefore, it’s not surprising that today’s power industry executives are devoting significant time trying to predict when power usage will return to pre-recession levels and when their customers’ demand for electricity will grow again. These kinds of economic uncertainties distract power and utility organizations from thinking about, and devoting, significant time to M&A.

And until the economy returns to, or exceeds, pre-recession times, there will continue to be a cloud over M&A activity.

On the legislative front, the industry is, by and large, maintaining a wait-and-see position regarding federal energy policy, especially as it relates to carbon emissions. Until the United States establishes clear rules on carbon and other energy-related initiatives, it will be difficult for power and utility organizations to gauge the impact of new or incremental environmental costs and to devise plans to recover those costs.

Yet, organizations contemplating an acquisition must take into account environmental considerations, especially if the target has a generation component that relies heavily on fossil fuels. Are the target’s facilities outfitted with updated emissions control equipment ( e.g., scrubbers) and is the company ahead of the curve when it comes to meeting other environmental requirements relating to fossil fuels? Legislative uncertainty constrains industry M&A activity because of the difficulty in predicting how much it

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