The article "Electric Utility Mergers: The Answer or the Question?" (by Robert J. Michaels) in the January 1, 1996, issue, along with current events involving my employer, a midwestern utility...
Capitalizing on Consolidation
The number of shareholder-owned electric utilities has declined by 48 percent since 1995. Over the next decade, we expect to see two or three deals per year, on average. At this rate, the number of U.S. investor-owned electric utilities would be reduced to less than 40 by the year 2020. Although the pace of consolidation remains moderate relative to other industries, it is a significant disruption to the utility industry. Indeed, some utilities are likely to move forward into the M&A fast lane in the next three to five years, opening up the potential for the largest utilities to grow even bigger.
A number of factors and forces are easing the path to consolidation in the industry.
Variations in operational performance across the utility industry indicate significant improvement potential—what we identify as “untapped value.” For instance, some companies are spending three or four times as much as others per customer for critical functions such as customer care. While elements of this discrepancy can be explained by regional differences, regulatory requirements, and similar factors, the majority of the performance gap is due to inefficiencies in the industry and to regulatory constructs which do not incentivize utilities to drive operational and cost improvements. Industry-wide, there is approximately $4 billion annual operations and maintenance (O&M) untapped value, which is roughly 10 percent of the annual O&M spending for the industry. As we can see in Figure 1, there is significant variance of performance in each of the three major O&M categories—transmission and distribution O&M per customer, customer care O&M per customer, and administration and general O&M per customer. In all cases, there is a long tail of performance in the fourth quartile.
In the context of this untapped value, there is considerable potential for higher-performing companies ( i.e., first and second quartile performers) to acquire lower-performing companies ( i.e., third and fourth quartile performers) and yield operational benefits for their customers and shareholders.
Recent economic recessions have played a significant part in merger activities over the last two years. For instance, more than 75 percent of the mergers involved acquirers with lower three-year revenue growth buying companies with higher three-year revenue growth. Many utilities have seen customer load significantly decline—a greater than 20 percent reduction over a five-year period for a few utilities.
In addition to the more recent financial crisis, future uncertainties could drive those with higher economic risks to consolidate as a means to diversify their portfolio. Depressed interest rates are softening the pressures from these economic uncertainties, but the historic lows will not last forever. M&A has been—and will continue to be—used to diversify a utility’s exposure to an economic region and customer base, to increase the contribution from regulated earnings, and reduce wholesale exposure through a natural retail hedge. These factors have driven many mergers in the last few years and will continue to do so in a low-growth, more uncertain environment.
ROE and Capex
In the past 15 years, there has been a steady decline in allowed return on equity (Figure 2). While to a certain