Where Have All the Mergers Gone?

Deck: 

EPACT and the repeal of PUHCA have not affected the pace of utility acquisitions.

Fortnightly Magazine - June 2007

Why do we still have several hundred shareholder-owned electric utilities in the United States, not to mention several thousand municipal and cooperative ones?

In the early to mid-2000s, one of the topics that set the electric utility industry abuzz was the prospect for consolidation through mergers and acquisitions (M&A). The idea, particularly in states with “customer choice,” was that utilities of larger size would have a cost advantage in providing services to customers. Among the load-serving entities, the idea was that larger ones would have lower costs per customer for such functions as customer service, billing, transmission and distribution O&M, and possibly financing. New information technologies would make it more economic to serve larger numbers of customers from the same network. New techniques such as business process outsourcing (BPO) would make consolidation attractive, since it would lock in savings. In short, they would achieve “economies of scale.” Further, in the generation segment, larger entities (both utilities and IPPs) could achieve “critical mass” whereby they could grow their portfolios to optimize between merchant and PPA-style projects, participate effectively in competitive markets, and have greater purchasing power with regard to fuel and other commodities, as well as more financial strength.

Thus, in all segments of the electric utility business, particularly shareholder-owned ones, the idea was that “bigger was generally better.” One subsidiary of a major accounting firm stated resolutely in a 2006 article that “due to industry consolidation, it is very possible that within 10 years there will be only a handful of utilities that are served by a handful of asset managers and service providers.” Hmmm.

Of course, even with such consolidation, it was recognized that electric utilities would continue to be closely regulated by the states with regard to retail rates and facility siting, and by FERC with regard to transmission access and tariffs. Within the regulatory framework, however, there was widespread belief that the force of scale, of technology, and of logic favored removing impediments to utility M&A to achieve both shareholder and customer benefits.

Pre-EPACT Activity

In the years just before the passage of the Energy Policy Act of 2005 (EPACT), however, few such transactions took place. So what was holding things back? One thing: the Public Utility Holding Company Act of 1935 (PUHCA). Indeed, PUHCA was believed to be one of the major impediments to such consolidation. PUHCA was passed in an era of clear abuses, and intentionally made mergers and acquisitions (M&A) difficult, as it: limited and regulated the businesses that electric utilities could enter into; controlled holding company dividends and transfers from the utility subsidiaries; regulated self-dealing; and imposed limits on acquisitions, particularly for non-contiguous utilities. The advocates of removing this impediment argued strongly that due to the opportunities from consolidation, and due to better means of regulation compared to seven decades earlier, PUHCA had outlived its usefulness. In a world without PUHCA, many of the chains restricting utilities from lowering their costs and undertaking dynamic change would be removed, and investment by non-traditional participants in the power sector would blossom.

In particular, the electric utility industry was starved for innovation, dynamism, and capital, as it was staid and conservative. Plus, PUHCA was the barrier putting the industry on a diet. Absent PUHCA, it was thought that pent-up capital would participate actively in acquisitions in the utility sector from such industries as: oil and gas companies; overseas (especially European) utilities; financial entities such as equity and hedge funds; and other infrastructure-intensive entities such as telecomm companies. As a result, the new owners would realize the efficiencies and economies mentioned above in a drive to seek higher returns.

On Aug. 8, 2005, the advocates of these positions achieved their goal when the president signed EPACT. The repeal of PUHCA was not complete, in recognition of the potential abuses of utility holding companies that the framers of PUHCA had memorialized. To balance the removal of most of PUHCA’s protection for consumers, EPACT inserted additional provisions allowing greater federal and state access to the books and records of utilities when M&A deals were proposed.

PUHCA focused on oversight by the Securities and Exchange Commission (SEC), while EPACT effectively eliminated the role of the SEC. In its place, it vested the Federal Energy Regulatory Commission (FERC) and the states with the primary responsibility to review proposed M&A deals and protect the public interest. It was expected to open the door to a wealth of utility M&A activity.

Fast forward to nearly two years since the passage of EPACT 05. In light of all the optimism and expectations surrounding utility M&A, it is appropriate to ask: Has the M&A activity that was expected actually occurred? Have the corresponding customer benefits and cash infusions that were anticipated from consolidation taken place? What does this mean for the future?

The answer as to whether M&A has risen in the past few years is a resounding no; in fact, it’s almost a deafening silence, as utility deals have not taken place in any meaningful amounts.

• Over the past two decades, utility M&A peaked between 1997 and 2002, when there were a total of 58 successful transactions—an average of almost 10 per year—and more were proposed that were not successful.

• Beginning in 2003, however, the pace of utility transactions dropped off dramatically, averaging only two per year from 2003 through 2005. This is the pre-EPACT lull that observers thought would be remedied by passage of the legislation.

• Since 2005 and the passage of EPACT, the pace of successful electric utility acquisitions has been at a similar pace, or two per year. In other words, no change.

Thus, EPACT and the removal of the PUHCA impediment does not seem to have affected the pace of utility acquisitions. While each individual deal is critical to its participants, and most have involved large entities, utility M&A since then across the nation has generated a collective yawn. Perhaps there would have been even fewer deals had PUHCA remained in place, but the fact remains that PUHCA’s evisceration, if not its complete elimination, in EPACT has had no perceptible impact on utility M&A.

Is Less More?

Both before and since EPACT, the only segment of the private sector that has participated in M&A activity outside of electric utilities themselves has been the financial institutions, in particular the hedge funds and equity funds. No new European utilities have entered the United States (though some already here have been involved in the deals that have proceeded); no oil and gas companies have done so; and no other infrastructure-intensive or other regulated industries (e.g., telecomm, gas) have done so either.

Overall, the reason for such lack of activity is that utility M&A is a complex consideration that involves much more than the restrictions imposed by PUHCA. That is, the presence of potential efficiencies may be necessary, but is not sufficient to support a utility merger or acquisition.

What are some specific reasons this might be the case? Some commentators have suggested that state approvals have become increasingly difficult to achieve while maintaining the financial benefits of the transaction (some cite state “mini-PUHCA” statutes). But while state approvals can be challenging, there is more to the story.

Barriers to Entry

Why might a successful entity in another industry not want to get involved in the electric-utility business? Electricity might not create a sufficient hedge to the core businesses, or managing the electricity business may be unfamiliar turf. Perhaps there are more pressing needs, or better uses of capital within industries

On his or her own, an industry executive might be able to get past these barriers, but financial structure and “bottom-line” reasons also might give a potential acquirer pause. For example, some electric utilities may be fully valued, if not expensive. Tens of billions of dollars in investment are required across all segments of the industry in the next decade, and taking on that substantial burden might not be prudent. Also, long-term returns may not be attractive, and may have limited upside.

Furthermore, in an industry with few qualified buyers, the “exit” strategy could be unclear. In addition, the utility’s tendency to utilize debt is higher than in most industries, so it might affect the parent company’s credit rating.

Then there are issues related to industry dynamics. There may be major challenges of merging utility cultures, which could limit the realization of synergies and transfers of skills. In fact, consolidating staff and implementing a major outsourcing effort can be significant challenges.

Moreover, because of competition and contracts with others, utilities might not be able to take advantage of vertical integration (e.g., access to coal or gas). Then again, the biggest reason a deal may not get done is the because of the perception that the best utilities may already have been acquired.

The Regulators

There are a number of concerns over regulation, both initially and once an acquisition is completed, which eventually may prevent a merger from happening. Potential acquirers may perceive that FERC or state oversight could make the acquisition a long, expensive, and uncertain undertaking at the outset.

Furthermore, the cost of approval (particularly if multiple states are involved) could eliminate most if not all of the anticipated savings/returns. Acquirers also may be reluctant to go from a modestly or minimally regulated situation to a highly regulated one. In fact, regulation could limit their ability to achieve fund improvements and investment through siting new facilities (e.g., approval of new transmission lines). Then there are the many new regulations being implemented (e.g., CAIR, CAMR) and anticipated (CO2 regulation) that pose an uncertain cost and set of challenges.

Facing Facts

In summary, in light of this litany, it is not surprising that relatively few utility M&A deals are proposed, and even fewer are successful, in spite of the removal of PUHCA as a factor. In fact, it was probably unrealistic to expect that EPACT would eliminate these fundamental barriers to utility M&A. Rather, it appears that instead of there being an environment in which there is an incentive, we have one in which there needs to be compelling reasons for entering into a utility acquisition effort. It seems more appropriate to regard the “steady-state” level of acquisitions of electric utilities as the number before and after the 1997-2002 period—a couple per year. The years 1997-2002 were likely an anomaly, one characterized by “dot-com” mania, inflated stock prices, and “irrational exuberance” that provided expectations of growth in the utility industry that could not be sustained.

The Shape of Things to Come

Looking to the future, and using the recently successful and unsuccessful deals as signposts, what do we see in terms of the types of transactions likely to take place in the next few years?

Bigger deals will tend to dominate. Of the several hundred investor-owned utilities in the United States, perhaps 10 to 15 percent can be considered large; while most are medium-sized or smaller. If a utility is going to seek to overcome the barriers described above, it will tend to do so only if there is sufficient upside potential, for both customers and shareholders, and if that potential is greater with larger transactions. Most of the deals, both successful and non-successful (e.g., MidAmerican-PacifiCorp; Duke-Cinergy; FPL- Constellation and Exelon-PSEG) fall into this category.

Furthermore, a handful of not-so-large utilities will acquire their peers. Within the medium and smaller categories, we would expect some future acquisitions. Those deals are “big” relative to the size of the merging companies, if not large in terms of the market. These deals will tend to be among contiguous utilities, and will be proposed primarily to achieve the hoped-for economies of scale that may be more readily realized in this size category. Because of their size, these deals will tend to raise few market-power concerns, involve fewer states, and cause less regulatory pushback.

The huge amount of investment required will facilitate some M&A activity. EEI estimates that among the shareholder utilities, $275 billion will be required in generation between now and 2030; $32 billion in transmission over just the 2006-2009 period; $13 billion to $14 billion in distribution per year for the next 10 years; and $50 billion in new environmental expenses through 2025 (and more if there are stringent CO2 regulations).1 This unprecedented need for capital will favor utility acquisition by those able to raise and sustain the level of investment required.

Limited non-utility participation in utility M&A will continue. We expect that the primary (if not the only) segments that will undertake utility M&A for the next several years will be the two that have done so in the past few years: existing U.S. utilities (whether owned by foreign entities or domestic ones) and hedge/equity funds. The recent offer for TXU by TPG and KKR is a prime example of the latter type. It is an open question as to whether the funds will have a continuing appetite for utility acquisitions outside of “marquis” deals, given the questions that regulators tend to have about their long-term commitment and the limited upside on returns, unless the utility can be split into regulated and unregulated entities.

Collectively, we expect these factors to lead perhaps to a somewhat higher level of activity than in the “steady state” period just before and after the passage of EPACT, but nothing close to the level expected before the legislation was passed.

The utilities industry will be exciting in coming years for many reasons—but an abundance of utility M&A deals will not be one of those.

 

Endnote:

1. Figures provided by David Owens, EEI Executive Vice President, in a presentation to the NARUC Winter Meetings on February 19, 2007.