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.
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 will cost to comply with new laws, should they be enacted.
For years, the United States has been preparing to control greenhouse-gas emissions either through existing regulatory authority or new comprehensive legislation. Meanwhile, power and utility companies continue to endure a protracted period of assessing risks versus opportunities in a carbon-constrained world.
In addition to proposed federal legislation, the heavily regulated power and utilities industry must comply with rules and laws that vary widely among the states. Compounding divergent state regulation complexities are federal laws and regulatory trends that tend to be influenced by a demanding customer base.
Certain regulators, depending on the state jurisdiction, also are taking a more active role in sector activities. Examples of this growing trend include the recent decision by Florida regulators to virtually deny two public utility requests to raise rates. State regulators in Maryland and New York also recently took actions that curtailed or made it difficult to divest nuclear generation assets.
Power and utility organizations looking to become M&A participants, when requesting transaction approval, either as potential inbound investors, or as U.S. entities, must recognize how important it is to understand the regulatory climate where the target operates.
Commodity price volatility is yet another cloud over the hope for a turnaround of industry M&A activity. Currently, the forecast for natural gas prices appears to remain in the $4 to $5/MMBtu range, and coal prices likely will continue rising, albeit at a slow pace. Additionally, the country needs new base-load generation in several regions. Current commodity price forecasts for fossil fuels could make it difficult for new coal and nuclear plants to be cost competitive with gas plants.
From an M&A transaction standpoint, it will be more difficult to value an entity that’s heavy on coal, particularly when factoring in the environmental spend on coal-burning plants. For the foreseeable future, it appears that companies with existing nuclear and gas-fired power plants are in a much better valuation position today than those that primarily burn coal.
Access to capital and a company’s market value are closely tied to the recovering economy. Like many other industry sectors, certain power and utility companies were downgraded during the recession, which made access to capital to finance transactions or capital improvements scarce, expensive, or both because of changes in investment ratings. And so the condition puts into question whether a buyer would want to merge with a company experiencing credit quality issues.
When analyzing asset valuations, there remains a spread, although it is shrinking, between the bids and asks for merchant-generating companies, as well as generation assets.
A silver lining in a cloudy economy is that the potential for M&A activity may be improving because of the potential availability of debt-distressed assets in the short term.
Certain merchant companies and other financial investors that bought generating plants within the past five years are facing significant debt payments in the near term. Because of demand destruction and low prices for gas, these generating plant owners aren’t hitting the cash-flow targets expected when the investment was made.
Infrastructure funds sitting on large sums of cash are eyeing regulated utilities, generally below an $8 billion market capitalization. This interest is expected to continue as infrastructure funds look to the power and utilities sector as a way to balance their overall portfolios with steady cash-based returns available from regulated utilities. As more financial buyers form these funds, there could be more competition than in the past for sector acquisitions.
Providing another potential boost to M&A activity is the industry’s return to basics. Regulated utility companies are expected to continue divesting themselves of noncore assets. Examples include the moves by Dominion Resources to spin off its exploration and production business and Duke Energy selling its natural gas business.
The rationales for these types of moves are to enhance shareholder values and also to answer the question of whether an entity is a power company or an energy company. As regulated utilities continue selling off the noncore parts of their businesses, such activities should create a bright spot for M&A transactions going forward.
All the industry’s M&A drivers will be affected by renewable energy and the increased attention it’s drawing within the power and utilities industry.
Many states have unique renewable portfolio standards that companies must meet. And so there is growing interest from inbound investors, including sovereign wealth funds, infrastructure funds, and foreign power companies, all of which see the renewable energy space as a window of opportunity because of the tremendous amounts of new capital required to meet those standards. They also fully are aware of the current government economic assistance available to the sector via the American Recovery & Reinvestment Act.
Renewable energy is expected to have a positive effect on M&A activity, but that optimism largely is contingent on the continuation of federal tax incentives.
The extent of renewables growth also will depend on new transmission line construction to move power from where these renewable energy facilities are being built to where the power is needed. Additionally, fossil-fuel commodity prices, currently experiencing a competitive advantage over renewable energy sources such as solar and wind energy, will play an important role in influencing M&A activity.
All these trends, from energy policies to commodity prices, will continue driving M&A activity for the next 12 to 18 months. Although it’s difficult to forecast whether the trends will last or fade quickly, an improving economy along with the announcement of several deals in early 2010 are expected to result in more, not fewer, deals within the power and utilities industry.