U.S. companies' international strategies turn sour, as Europe faces a future with an oligopoly of power companies.
While the European Union is pushing to give all industrial and commercial customers electric choice by 2004, giant incumbent European utilities are increasingly dominating power markets across Europe and the United Kingdom.
U.S. companies have exited the United Kingdom and Europe in droves. Had the E.U. energy ministers' decision come a few years earlier, U.S. companies might have been in a much better position to take advantage of the opening.
But the decision has been a long time coming. After all, the European Union directed that its 15 member nations open their transmission systems to competitors back in 1996.
Today an oligopoly is developing in which as few as five or six major power utilities-including France's state-owned EDF nuclear giant, Italy's largely state-owned Enel, and Germany's privately owned utilities E.ON and RWE-could dominate European and U.K. power markets in a few years, experts say. Other contenders include Belgium-based Electrabel; Spain-based Endesa and Iberdrola; Sweden's state-owned Vattenfall; and France-based SUEZ.
None of the top utilities is based in the United Kingdom, but some have made significant inroads there. E.ON, for example, has acquired British utility Powergen, a move E.ON has described as an important step in implementing its international expansion strategy.
The future for competition on the Continent isn't at all promising. Unlike the United Kingdom, which broke its state-owned electric system into generation, supply, and distribution packages and sold them to competitors, European nations have not required massive divestitures that would break up the vast holdings of incumbent utilities. Most of the European nations have incumbent utilities that dominate their markets. Would-be competitors face the daunting challenge of competing against the incumbents' entrenched networks of generation and transmission facilities.
Matthew Jarman, director of European utilities for global investment bank Lazard, says the dynamics vary from nation to nation, but that, other than in the United Kingdom, the breakup of major utilities has not occurred. While some attempts have been made to limit the growth of incumbents in Germany, Italy, and Spain, Jarman wonders how far new competitors can go in these markets.
"It is going to be tough for new players entering overseas markets because they are going to be up against a strong incumbent, and the question is, what are regulators or governments going to do to weaken the position of that incumbent?" Jarman says.
Far from "liberalizing" the European market, the effect of a classic oligopoly is to establish a structure of rigid prices. Each firm knows its price and share of the total market will affect the price and output decisions of the other members of the oligopoly. Tacit or collusive agreements develop because of this marked degree of interdependence.
As a result, to the extent that there is competition, companies focus primarily on areas outside of price. The companies may offer variations in service or less productive responses such as "packaging" and advertising. However, the main thrust of competition, namely to lower power prices through competitive gains in efficiency, is lost.
Better-Financed Europeans Vie for "Cozy" Oligopoly Position
The major European energy companies are far bigger than most U.S. utilities, and they are in much better financial shape. Anthony White, managing director of European Utilities Equity Research at Salomon Smith Barney, says that market rules have been liberalized in some countries, including the United Kingdom, and can be changed in the other European nations so that anyone can build a generator.
However, if the present trend toward consolidation continues, a few companies could occupy all the markets of the United Kingdom and Europe and keep prices just below the point where it would be profitable for new market entrants, White says.
"Maybe it is better to have a cozy oligopoly where the generators keep price stability just below the new entry level. [Then] there is the threat of competition. If these guys set prices too high, they lose market share, so you've got some protection there.
"Electricity is incredibly capital-intensive and very political. I don't think governments tolerate highly volatile prices. Therefore, why not go for a cozy oligopoly where customers are protected from higher prices?" White asks.
Meanwhile, despite the expressed intent of the European Union to have open competition, the incumbents have the money and the political connections to enter markets elsewhere without having to face serious threats from competitors at home.
"We are finding very strongly that promulgating legislation does not translate necessarily into effective competition," says Scott Foster, an analyst in the Paris office of Cambridge Energy Research Associates (CERA). "In other words, the legislation is necessary, but not sufficient."
The move toward liberalization has lost momentum. A worldwide recession, depressed energy prices, worries over security of supply, fears of price spikes, environmental issues, and employment concerns have taken the air out of the impetus for a competitive market that could bring lower prices.
As a consequence, incumbents are protected. For example, Italy's Enel is 68 percent state-owned, and the big dividends reaped from consumers of overpriced electricity are diverted to other government expenditures.
Tanjuy Le Quenven, director of European Power Research for CERA in Paris, says that not every E.U. member is on the same page, despite E.U. pronouncements.
"The French state has always been very reluctant toward liberalization," he says, partly due to concerns about what that would mean for its nuclear complex. "In the French tradition there is always a suspicion against market opening because there is more of a tradition of centralized planning for energy."
The government has said it would move to privatize EDF, but no timeline has been given, he says.
"The opponents of liberalization in Europe have gained some arguments because of the California crisis and the withdrawal of U.S. merchant players from Europe," Le Quenven says.
Acquisitions Continue
Add to this severe physical limitations in the transmission of power across national borders throughout much of Europe, depressed power prices, and a debilitated trading market, and what emerges is a food-chain form of competition in which the big compete for opportunities to gobble up the small.
"The path we are on is leading to ever more consolidation in the market, with five or six major utilities establishing significant positions across Europe," CERA's Foster says.
The favorite way of "winning" customers in Europe is to buy them by snatching up municipal distribution companies, he says. Germany and Italy are the ripest markets for this. U.S. companies that leave the European scene are selling assets. In some cases, governments are requiring divestitures to encourage at least token competition. But for the most part, acquisition purchases in Europe are fairly limited. While the likes of E.ON and EDF have substantial war chests, they are discouraged by protectionism in one another's markets.
But certain European markets need more generation capacity. Italy and Spain need new plants. That could open up opportunities for new competitors.
The Finnish Energy Industries Association has reported that during the next 10 years an estimated 60,000 MW to 70,000 MW of additional electricity production capacity will be needed across much of the E.U. member states. The European Union has estimated its members will need 200,000 MW to 300,000 MW during the next 20 years to cover increased consumption and plant retirements.
How U.S. Companies Lost Out
Salomon Smith Barney's White says U.S. utilities overpaid for assets in a rush to enter the U.K. market and wrongly assumed that the revenue streams from the assets would pay for the financing of these acquisitions. "AES, Edison Mission, TXU, AEP, and others assumed that prices would not fall. Their horrendous mistake was to sign long-term off-take contracts, which came out of the money," White says.
Companies that bought distribution assets also made mistakes in the United Kingdom, White says. They paid high prices for distribution utilities, assuming that they would run the companies more efficiently and save money, and that regulators would let them pass on the premium cost to ratepayers. They assumed wrong. Every five years regulators in the United Kingdom set prices based on what they think will be a reasonable return on capital.
"The regulator sees what the cost savings are and passes them on to the customer," White says.
The major vertically integrated players of Europe have been more patient, and in so doing they have been able to take advantage of the "going out of business" sales afforded by U.S. departures. Vertically integrated utilities now dominate the U.K. market. Thus, while there has been a drop in wholesale prices due to surplus generation capacity, vertical integration allows the players to reap wider retail price margins.
Lazard's Jarman says that consolidation is occurring in the United Kingdom among power producers. "You are likely to see the remaining independent power producers consolidating or getting out of the market over time," Jarman says. "Some of the merchant players are disappearing, and the wholesale market is likely to consolidate to maybe six or seven players of size."
Jarman expressed the view that competition would continue, but perhaps in a more stable manner than has been seen recently.
Edward Tirello, managing director and senior power strategist for Berenson Minella & Co. of New York, points out that volatility in the power markets brought down many newcomers. U.S. companies, including Enron, Reliant, and Mirant took large positions in power trading in Europe, and when the market collapsed, the bigger, stronger European conglomerates and government monopolies stepped in, Tirello says.
Dynegy, Aquila, AEP, Duke Energy, El Paso, and the Williams Cos. also have closed or scaled back trading operations in Europe. European companies have assumed greater power trading roles.
"You are going to have big companies dominating the story-probably a dozen or so. The big dozen will just get bigger," Tirello says, speaking of the full spectrum of the power business from production to retail sales. "As the markets open up they will compete against one another to hold customers."
Some experts see little room for a return of U.S. energy companies as competitors. Jonathan Rubin, president of New York-based Ikor Energy Advisors, a consultancy, says U.S. companies have lost whatever opportunities they once had in Europe and the United Kingdom.
"We came, we saw, we left. … I think we are better off staying home, frankly," Rubin says. "I don't think the U.K. is the place you want to be unless you are a vertically integrated player. That is true for most of Europe."
With the tensions between the United States and Iraq and the possibility of oil price spikes, now is not the time to venture abroad, Rubin says.
"Given the global economy, it would be best to stay at home, get the balance sheets cleaned up, and focus on core capabilities," he says.
Antitrust May Limit Dominant Players, but U.S. Exit Continues
Britain's antitrust laws will come into play eventually, other experts say. "It's a question of who hits the buffers on anti-trust first," Jarman says.
Antitrust issues could limit the expansion of major incumbents in Europe as well, Jarman says, pointing to the problems E.ON is having in gaining approval to buy Ruhrgas, at press time.
While E.ON lost shareholder value due to the decision, it still has billions of euros to spend outside Germany. In fact, in late December, E.ON announced that its supervisory board had approved a planned capital spend of 14.2 billion euros ($14.56 billion) for the next three years.
The giant utility, which posted 2001 sales of almost 80 billion euros, said its operating cash flow would markedly improve its net financial position, giving it considerable financial flexibility to fund major strategic acquisitions.
Furthermore, the European Commission-the executive body of the European Union-recently approved E.ON's 2.17 billion euros ($2.23 billion) purchase of U.S. investor-owned utility TXU Europe, with its 5.5 million retail power and gas customers. E.ON will combine that acquisition with the 3 million customers E.ON acquired in its purchase of Powergen for about 8 billion euros earlier this year. The bargain price for TXU Europe was the result of a depressed power market that pushed the company into protection against creditors.
TXU also has been hammered in Germany, where it has announced plans to sell controlling stakes in utilities in the cities of Kiel and Braunschweig.
Even in Britain, where competition has been encouraged, U.S. companies have found it rough going in competing against dominant European utility companies.
American Electric Power, while sticking with its generation assets, sold Seeboard, its 2-million-customer retail electricity, gas supply, and distribution subsidiary in southeast England, to London Electricity Group, an EDF company.
Kansas City, Mo.-based Aquila and minority partner, Akron, Ohio-based FirstEnergy, put U.K. power distributor Midlands Electricity on the auction block.
Duke Energy announced Dec. 17 it would fold its United Kingdom and French power trading operations to focus on gas trading in the United Kingdom and Holland. In September, Duke announced it was pulling the plug on power trading in Germany and the Nordic region.
And in the United Kingdom and Europe there have been a series of other cutbacks and closings of trading operations. Dynegy, Aquila, AEP, El Paso Corp., Reliant Resources, and Williams Cos. have all retreated, while investment bankers have started trading deals with EDF, RWE, and others. The European Federation of Energy Traders continues to push for improvement of energy trading conditions in Europe and furtherance of international power and gas trading.
"Americans who came over to buy European assets have gotten clobbered because generally they bought at too high a price," CERA's Foster says. "The more patient European money is moving in the other direction [of buying rather than selling]."
Dan More, managing director of Morgan Stanley's Global Energy and Utility Group, says the financial deterioration of U.S.-based companies and unanticipated competition from European companies were major factors in decisions of American companies to withdraw.
"It's been about a 10-year round trip. These U.S. companies with excess cash flow in the early '90s went in search of higher returns, which appeared achievable in Western Europe," More says. "They had some successes and some not-so-successful ventures, but the bottom line was the higher returns were not easy to achieve or retain.
"As these companies have started facing challenges at home, it became apparent the capital could be better used in their base business, which is, as we see, a back-to-basics strategy," More says.
More adds that much of the competition came from very strong, entrenched incumbents. Further, pressure from shareholders has been an issue.
"The U.S. utility investors, institutional and retail, have tended to be nervous and skeptical about overseas ventures," especially in light of the downturn in investor confidence in the power markets, More says.
E.U.'s Attempts to Open Market May Be Too Little, Too Late
The E.U. Council of Energy Ministers finally reached agreement last Nov. 25 to completely open electricity and gas markets for all commercial and industrial customers by 2004, including the establishment of independent regulators and separation of transmission and distribution functions from generation and supply services. However, that decision does not in any way include unbundling of ownership in vertically integrated companies.
In the name of competitive, open markets, long-running debates continue to take place in the governments of European capitals where decisions will be made on how the E.U. council mandate should be implemented. Presumably, the energy ministers' deadline now gives those debates more focus.
The current calendar year is a "crossroads" in Europe, says CERA's Foster. "This is where the debates play out. If they get it right they can slow the migration of heavy industry to other regions."
However, the E.U. council's mandate for full opening affects only a few countries, most notably France, Foster says, and even for those countries there will be a review process before the final stage of market opening.
"Within those requirements, governments have a lot of leeway on application," he says.
For example, some parliaments will discuss whether to privatize government-owned utility holdings. And that will include debates over how to balance budgets, provide employment, and ensure competition and energy security, he says.
"This is a crucial year for determining how much political will a government has to pursue one path or another," he says.
Still, policies and laws so far have allowed incumbents to keep the home-field advantage.
The European Union recently began proceedings against protectionist laws in Spain and Italy that were designed primarily to keep EDF from acquiring assets in those countries. Italy and Spain reasoned that since France hadn't reciprocated by allowing acquisitions of French assets, EDF shouldn't be allowed to buy Italian and Spanish assets.
The German constitution prohibits interference with private property ownership, thus ruling out forced divestitures. That could protect large incumbent players, especially E.ON and RWE.
Many outsiders are critical that Germany lacks the regulatory authorities to uphold grid access provisions.
Germans argue that their nation was one of the few E.U. states to grant supplier choice to all customers. Yet, large players increasingly dominate that market. In addition to E.ON and RWE, the only competitors that have made significant inroads are EDF, which owns 35 percent of ENBW, and Vattenfall, which has 90 percent control of BEWAG and a majority of the VEAG and LAUBAUG utilities.
France, with its primarily government-owned EDF nuclear utility, isn't a good candidate for divestiture, observers note. Breaking up the huge nuclear utility would be inadvisable from an efficiency and possibly a safety standpoint, they say.
At the same time, suppliers of power customers need to either own generation or have good contracts with power producers to back their obligations to customers, says John Easton, Edison Electric Institute's vice president for international issues.
"If all your generation is in the hands of one provider you are not going to have as effective competition as you would with generation in the hands of many," Easton says.
While prices are depressed in the United Kingdom, the future for industrial and commercial customers is likely to include higher prices.
Foster says big industry is looking to China and other developing regions where power is cheaper. That threat puts pressure on governments to encourage competition as a means of holding down prices.
Still, many experts see little hope for adventurous newcomers.
"I think the opening of the European market will primarily benefit larger European companies, and in particular EDF and the German utilities who are presently doing many of the acquisitions across Europe," says Easton.
U.S. companies would have benefited far more had the European Union set the 2004 deadline for commercial and industrial customer choice a few years earlier, Easton says.
Some Observers Still See Opportunities
However, Easton wouldn't rule out the possibility of robust competition throughout much of the Continent and the United Kingdom.
The European agreement provides for unbundling of transmission and distribution functions, Easton says. "More than market power concentration, the access to the grid is the real critical thing for competition," he adds.
Even if incumbent utilities acquire and control vast amounts of generation capacity across Europe, open access would allow new players the opportunity to come in and attempt to build new plants more economically and run them more efficiently, Easton says. As older plants are retired and demand inevitably grows, the incumbents will face competitors, if interconnection and transmission access is provided, he says.
"It may well be that some merchant can come in and build a power plant more cheaply than the incumbent can," Easton says. "The more critical aspect here is rules and regulations providing grid access."
Even while open access may be granted within E.U. states, cross-border transmission capacity is often constrained. Transmission bottlenecks are especially critical on the borders between France and Spain; West Denmark and Germany; Belgium and the Netherlands; Italy, France, Switzerland, and Austria; and the interconnection between the United Kingdom and continental Europe.
The limits on transmission infrastructure result in Balkanized power markets for Britain, Central Europe, the Nordic Region, the Iberian Peninsula, and Italy.
Patting itself on the back, the E.U. and the European Commission say the E.U. energy ministers' decision to liberalize electricity and gas markets is nothing short of revolutionary and will give consumers full freedom to choose their energy provider. Perhaps. Yet, in its present form, consumers may get to choose from only a handful of European providers-competition in a much more limited form.
Europe's Big Players: A Reference
EDF (Electricité de France): The biggest and most aggressive European giant is pushing across Europe into virtually all major markets. The company has 31 million customers in France, sales revenue of more than 34 billion euros (including 23 percent outside France), and a power output approaching 500 billion kWh. In addition, EDF is in charge of the national transmission grid as well as the planning for future generating capacity.
Enel: Though it is the second largest electric power company in Europe, Enel faces domestic pressures for lower power prices in Italy. Enel and other generation plant owners in Italy are being required to reduce their capacity holdings. While the proceeds from the sales will be used to help Enel's Pan-European expansion program, Italy needs new plants. The government in 2002 moved to streamline plant permitting. While that could prove advantageous for competitors, in sheer size Enel has more than 50 percent of the market share in generation and more than 80 percent of the distribution assets in Italy.
E.ON Energie: One of German-based E.ON's six business divisions is the third largest power company in Europe and the largest privately owned European power company in terms of electricity sales, according to the company's own estimation. The energy division owns interests in and operates power stations totaling 50,000 MW, of which the division has an attributable share of 34,000 MW. E.ON Energie participates in energy markets in more than a dozen European countries. Notably, E.ON Energie has a 55 percent stake in Sydkraft, the second-largest utility in Sweden.
Essen, Germany-based RWE: Like E.ON, RWE is a multi-business corporation, but RWE Energie is, according to non-company sources, Germany's largest vertically integrated electricity company. In addition to merging with its neighbor, VEW, its acquisitions include Innogy in the United Kingdom.
Endesa: The principal electricity company in Spain has a strong presence in France and Portugal, but its expansion focus has been more in South America. It boasts control of 43,000 MW and in 2001 produced more than 133,000 GWh for 20.5 million customers. The vertically integrated company generates, transports, and markets power.
Iberdrola: Spain's second-largest vertically integrated power company is said to be in a less-flexible competitive position owing to its increase in debt, which limits its ability to make more acquisitions in Europe, but its home court advantage on the Iberian peninsula cannot be easily disputed.
Electrabel: Belgium-based Electrabel is rapidly expanding by acquiring assets across Europe, including the purchase of Tractebel's European assets. The company has slightly more market capitalization than the Spanish players do. However, it is facing a challenge at home, where the government is pushing for the retirement of Electrabel's nuclear plants.
French multi-utility corporation SUEZ: Until its sale of subsidiary Tractebel-seen as a retreat from the power sector-the company's far-flung holdings included more than 26,000 MW in Europe. Tractebel held a 44 percent share in Electrabel. SUEZ is still a dominant and nimble player, and could be a formidable competitor, especially with its interest in renewable energy. Until recently the company deemed itself one of the top 10 independent electricity producers in the world.
Vattenfall: The largest Scandinavian power company has taken a leading role in Northern Europe. It has moved into Germany with the assumption of nearly all of Bewag, including acquisition of U.S. merchant generator Mirant's stake. It has assumed ownership of three other German utilities.
-J.S.
One company takes the money and runs, while the other decides to stick it out.
"The only company that made money was Dominion Resources. They bought East Midlands and sold it quickly to Powergen. They found someone else willing to pay the ridiculous price," says Anthony White, managing director of European Utilities and European Equity Research at Salomon Smith Barney.
Dominion Energy spokesman Mark Lazenby recalls that Dominion divested its U.K. portfolio in 1998, the year following the company's purchase. The intent of the purchase was in part to merge with another distribution company and squeeze efficiencies by eliminating duplicative back office operations. However, a merger partner could not be found. Further, the Labor government wanted to levy an unexpectedly high windfall profits tax. "We anticipated a windfall profits tax in our offer, but we viewed the Labor government as tax thirsty," Lazenby says.
U.K. regulators wouldn't let Dominion conduct its plan to market financial services, Lazenby says. The regulators thought they were being asked to grant an unfair advantage to Dominion to market financial products to its 2 million customers, when other financial service houses would want the same access, he says.
"Concurrent with those three developments was an unexpectedly good offer by Powergen for the East Midlands business. When this profitable offer came over the transom … we decided it was time to exit with a profit," Lazenby says.
White says that the other winners in the U.K. market as prices have fallen are those who sold more power than they produced and who did not pass on the savings to customers. In other words, they bought cheap power but sold it at retail at a markup. "The people who have won have sold more power to domestic customers than they generate at their own power stations," he says.
Centrica and Innogy have been winners, he says. "Innogy had a lot of generating stations but saw this was going to happen, so they sold their generating stations and bought customer supply businesses," he says.
RWE has since bought Innogy. Centrica has continued to be a profitable U.K. power and gas supplier and has aggressively pursued business in North America.
Pat Hemlepp, AEP's director of corporate media relations, says AEP has decided to tough out the low market prices in the United Kingdom by hanging on to the ownership of Fiddlers' Ferry and Ferrybridge coal-fired plants with a total capacity of 4,000 MW. "We have a strong team in London. Even with the poor prices, we feel we are well placed over there. … We feel we can ride it out."
AEP bought the plants from Edison Mission last year. More recently, AEP withdrew its trading operations from the Continent and is now trading only around the U.K. plants as part of a companywide strategy announced Oct. 10 to trade only in wholesale markets where the company has assets.
But E. Linn Draper Jr., AEP's chairman, president, and CEO, says he is "very disappointed" with the performance of the company's U.K. generation. "The generation has been cash flow positive, but market conditions in the U.K. have been terrible and power prices continue to be depressed."
Hemlepp says AEP's U.K. operations have had only about a 2 percent impact on the company's revenues.
-J.S.
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