Differences of opinion make for good horse races and bad jokes about economists, and those who are studying the recent wave of electric utility merger announcements have not let us down. Some of these economists optimistically believe that the mergers act as forces for competition, since they will combine corporate assets and staffs to bolster operating efficiency and market acumen at the merged companies. Other economists, who see transmission as the root of monopoly power, are more pessimistic. They expect that a merged system controlling more transmission will end up better able to deny competitive access and thereby harm competition. Most likely, both of these views will turn out to be incorrect or incomplete.
Optimists should note that the announced savings from utility mergers are small, speculative, and often obtainable by less drastic means. Regulation makes it unlikely that a merged system will create a more formidable rival to independent generators, marketers, or telecommunications purveyors. Pessimists should note that the Energy Policy Act of 1992 (EPAct) put important limits on transmission monopoly by empowering the Federal Energy Regulatory Commission (FERC) to issue wheeling orders. Those limits will become more stringent as the FERC gears up to compel utilities of all sizes to file open-access transmission rates.
Neither monopoly nor competition seems to explain the recent merger rush. Combining two large utilities can prove costly, time-consuming, and disruptive. At a time when management should prepare for market developments, a merger diverts its attention to a transaction of little apparent value. In ordinary markets, mergers, acquisitions, and takeovers can be productive, but here they seem otherwise. Utilities that merge may be preparing for politics rather than competition.
HOW HIGH THE SAVINGS?
The substantial savings projected for recent mergers largely reflect the size of the merging systems, which often announce their newfound efficiency in ways that encourage a sense of wonderment in lay onlookers. Merger announcements never discount expected savings to a present value so that the returns to a merger can be compared with returns on other investments. The announcements give only one figure, rather than a range that might account more accurately for the greater risks that will come with increased competition. They also omit any explicit accounting for regulatory risk. If recent experiences are typical, most mergers will require about two years to obtain the necessary regulatory and antitrust approvals. If any one agency disapproves, the merger may never take place. If an agency imposes unexpected conditions on the merger, some of the anticipated savings might also vanish.
Even without these qualifications, the claimed savings are never very substantial. The annualized $770-million, 10-year savings for Southwestern Public Service Co. and Public Service Co. of Colorado amount to 2.6 percent of current electric revenues and 1.2 percent of the book value of their assets. Since the two companies do not abut, they must link themselves with a 300-mile line costing several hundred thousand dollars a mile. Northern States Power Co. and Wisconsin Energy Co. expect $2 billion in savings over the next 10 years (3.3 percent of annual revenue); Potomac Electric Power Co. and Baltimore Gas and Electric Co. expect to save 2.6 percent of revenues. (Some of these companies also distribute gas.) Unregulated companies do not merge to save such small percentages of income.
Utility projections of merger-related savings are understandably optimistic, and will probably differ from those calculated by opponents. Yesterday's utility could project with more confidence than today's because its income stream, cost recovery, and political situation were all more secure than they are ever likely to be again. Some of today's utilities find themselves in tough situations because past projections of revenue and costs have not come true. Even if a merged utility realizes the savings, investors will not prosper if regulators insist on a passthrough to ratepayers. As for the ratepayers, let's assume that electricity makes up 5 percent of production costs (a very high share) for an industrial customer: A 2-percent post-merger price fall lowers that customer's total costs by only one-tenth of one percent.
LEAN AND MEANINGFUL?
Most savings from electric mergers are to come from sources that seldom motivate mergers elsewhere. In most announcements, two-thirds or more of the savings stem from staff reductions, investment deferrals, and related consolidations. Consider that fact. Utility-owned generation may have lost its natural monopoly, but the workforce of the merged companies has now become one. Any unmerged company that can only eliminate redundant employees by merger is a company with poorly designed job responsibilities. Oddly, merging utilities seldom target specific staff or functions for elimination. Instead, they intend to replace employees who depart voluntarily, and to fill in the vacancies by reassigning those who remain. If downsizing by employee attrition was good competitive strategy, unregulated businesses would use it more often. Ordinary firms, however, will more likely merge to acquire desirable employees rather than to lose them at random.
Only in odd situations will a merger leave the product better "positioned" for competition. In bulk generation, if one party enjoys an excess of low-cost generation while the other does not, regulators might insist on allocating the inexpensive power to native load. If neither partner can compete in the generation market by itself, a company that controls the aggregate of their generation also probably cannot. A merger cannot give a "first-mover" advantage in an industry where the important first moves have already been made. A merger between two utilities might employ their complementary skills for competitive advantage, but merger announcements seldom indicate what those skills might be.
A merger might allow some component of Utility A to function more effectively by embedding it into a combination of Utilities A and B. Utility B, however, might acquire the function more cheaply by contract than by merger, without combining other activities that a merger would disadvantage. If Utility A covets a particular piece of Utility B, it can buy just that piece, contract to share it, hire away the key personnel, or build its own on the same pattern. Electric utilities show a long record of ingenious and productive contracting. They routinely arrange diverse bulk-energy trades with one another, invest jointly in generation and transmission, share short-term capacity, and make contracts for a variety of wheeling and coordination services. Why should two utilities merge if they can arrange almost any efficient transaction by contract? If merging really saves hundreds of millions, why did utilities rely on contracts for so long, and why were managements and regulators so slow to notice the savings?
CAN A MERGER MONOPOLIZE?
Some commentators fear (and some utilities may hope) that a merged system will exert greater monopoly power over transmission. If a utility cannot profitably exploit its transmission before merging, however, it probably cannot do so afterwards. A monopoly can only overcharge if it restricts product availability, a difficult feat for a utility with obligations to serve at cost-based rates. Under open access, the withholding of transmission is unlikely, particularly if wheeling customers can reassign their rights and utilities must offer interruptible service on unused capacity. Whether or not mergers occur, utilities may soon have to surrender some of their control to regional transmission groups and wholesale pools.
Open access might alleviate transmission restrictions, but a larger post-merger utility could wield more monopoly power in energy than a smaller one. In bulk power, the FERC increasingly assumes that wholesale generation markets are competitive. A merger only harms competition in those markets if it somehow forecloses transmission-dependent systems from transacting beyond the merged territory. If there are such impediments, a fine-tuning of open-access policy may be in order. At retail, regulation will continue, and antitrust action remains possible. Mergers will not affect state regulations that restrict retail direct access or otherwise require final users to pay above-market prices. Larger utilities will only be able to exercise monopoly power at retail if state regulators let it happen.
ARE MERGERS LIKE TAKEOVERS?
An economically efficient business produces at low cost. It encompasses the right scope of activities and sells its product competitively. Efficiency grows more likely if investors actively compete for control of the business, since those who can better operate it will outbid others.
Investors can choose from numerous methods to compete for corporate control. A proxy fight may vote out an inept management, a well-run existing firm may acquire an ineptly run firm, or a merger may combine one firm's executives with another's. Most graphically, a takeover specialist can acquire stock and install management of its choice. This new leadership often changes the firm's financial structure and reshapes its scope by divesting inappropriate activities. In theory and practice, takeovers usually improve efficiency and make corporations more valuable. The financial restructuring puts investment decisions under closer scrutiny by the capital markets.
Today's mergers between adjacent utilities hardly serve as efficient takeovers. No recent announcement even hints that one partner has less than superb management, although it seems odd that so many good matches have only arisen so recently. No merging parties have announced corporate restructurings beyond such easy steps as the formation of a holding company. Merging utilities may often be unable to propose more radical changes. Regulation often restricts their corporate structures and imposes service obligations they cannot abandon. Bond indentures can add another expensive barrier.
Restrictions posed by the Public Utility Holding Company Act (PUHCA) further restrict competition for the control of electric systems. For all practical purposes, PUHCA limits a utility's potential merger partners to adjacent utilities or systems that can be reached by short transmission links. Acquisition of a utility by a nonutility seems unlikely, since doing so will trigger additional regulation of the acquirer's nonutility operations and finance. If Congress repeals or amends PUHCA, utilities may find it difficult to justify the current crop of mergers to shareholders. The utility that waits another year or two may gain important new choices without losing many of the old ones.
Unlike an ordinary corporation, an electric utility does not face a world of potential takeover artists who might impose radical change. Instead, only a few nearby entities in the same business can seriously think about merger or acquisition. It is little wonder that most utility mergers are "friendly," since they take place between long-time neighbors whose past has seldom been competitive. (PECO recently abandoned the only unfriendly transaction in the current crop (em its attempted acquisition of Pennsylvania Power and Light.) The friendliness of most mergers leads to concerns far removed from competition. Writing in The Electricity Journal (Oct. 1995, p. 11), utility merger attorney Douglas Hawes stated that the most important obstacle to a merger of "equal" utilities "is the difficulty of devising a succession plan that satisfies both the two CEOs and their respective boards." Recently consummated mergers have "all involved a contractually blessed plan of one CEO serving as CEO of the combined enterprise for a limited time, to be followed by the other CEO." Facing a maelstrom of retail wheeling and strandings that threaten billions in assets, utilities are choosing merger partners by the ages of their CEOs.
DO MERGERS MATTER?
Economic reasoning usually starts from a presumption that people are self-interested and pursue their interests as best they can. The owners of a business might do so by reshaping it into a better competitor, or possibly a better monopolist. Many of today's utility mergers, however, seem destined to do neither. One possibility remains.
Mergers or none, the future of the industry will be determined both by markets and by politics. Utilities with heavy stranding exposures or competitively aggressive neighbors may find it better to depend on politics than on markets to ensure their continued corporate existence. CEO James Rogers of CINergy Corp. recently stressed this proactive aspect of electric mergers, saying that they will produce "companies that are big enough to mold and shape future regulatory and legislative issues." (Inside FERC's Gas Market Report, Sept. 22, 1995) If Rogers is correct, then what merged utilities cannot get from customers with choices they will attempt to get from governments that restrict those choices.
More optimistically, even politics may not do much for the newly merged systems. A larger utility is both a better fortress and an easier target. Politically, small municipal and cooperative systems have more than held their own, while companies the size of the Long Island Lighting Co. may soon be socialized. Size was of little help to AT&T after competition became strong enough. Competition is emerging everywhere in the industry, in the face of determined opposition from established utilities. Today's mergers will not stop market forces, and they will not turn utilities into market forces of their own. Mergers do not necessarily produce political momentum. Nor is political inertia guaranteed by creating companies that are "too big to fail." If two merging utilities intend to build an ark for themselves, they should understand that the next flood will last longer than 40 days. t
Robert J. Michaels is a professor of economics at California State University, Fullerton, and a consultant at JurEcon, Inc. His research and commentaries on utility competition have often appeared in the FORTNIGHTLY and elsewhere. He is author of the entries on electricity and gas regulation in the Fortune Encyclopedia of Economics (Warner Books, 1993). The views expressed in this article are not necessarily those of his affiliations or clients.
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