Increased competition, rising fuel costs and a merger-friendly regulatory environment have triggered a trend towards consolidation in the US utility sector, writes Anne Feltus
BY 2010, mergers may have slashed the number of publicly traded US utility companies from 100 to 50. That, at any rate, is what some experts are saying and the evidence certainly points towards an acceleration in corporate activity. The value of power transactions in North America reached $62bn last year, about one-third of the worldwide total, according to a PricewaterhouseCoopers report.
After reporting strong earnings, improved profit margins and increasing equity values in 2005, utilities have plenty of cash. At the same time, they are under pressure from investors to build their bottom lines in an industry that has traditionally been characterised by low top-line growth. Mergers and acquisitions are time-tested methods of cutting costs, capturing synergies and achieving economies of scale.
But perhaps the biggest impetus behind the urge to merge was passage of the Energy Policy Act of 2005 (EPA05). Among other things, this landmark legislation repealed a regulation that has presented significant obstacles to consolidation since it was enacted more than 70 years ago.
Before the Great Depression, a handful of large, complex interstate holding companies controlled most of the US utility industry. However, a lack of effective regulation led to abusive business practices and eventually the companies collapsed, leaving many of their customers with high electricity rates and an unreliable service.
Congress responded by passing the Public Utility Holding Company Act (PUHCA) of 1935, which severely limited utilities' activities and banned mergers among utilities unless they are connected geographically. It also placed restrictions on how much stock a non-utility investor, such as an oil firm, bank or foreign investor, could own in a utility. As a result, the industry became highly fragmented.
EPA05 eliminates these ownership and geographical restrictions. It also expands the pool of potential merger candidates by removing provisions of the Public Utility Regulatory Policies Act of 1978 (PURPA) that placed restrictions on utility ownership of qualifying facilities.
Even before EPA05 took effect, plans for several large mergers had been revealed. American Electric Power (AEP) completed its acquisition of Dallas' Central & South West in 2000, in a $9bn transaction that created the nation's largest power-generator. However, the deal was ruled invalid by the Securities and Exchange Commission under the terms of PUHCA, because the companies operate in different parts of the country. Now, with PUHCA out of the picture, geographical diversity is no longer an issue, giving the deal a new lease of life.
The removal of PUHCA-imposed barriers also enabled MidAmerican Energy Holdings to complete its $9.4bn take-over of PacifiCorp, from Scottish Power, in March. Oregon-based PacifiCorp serves more than 1.6 million customers in six Western states and has a net generating capacity of 8.26 gigawatts (GW); MidAmerican Energy Holdings, an Iowa-based subsidiary of Berkshire Hathaway, an investment company, provides electricity and gas services to 5 million customers worldwide.
At year-end 2004, Chicago's Exelon announced plans to acquire Public Service Enterprise Group (PSEG) in a $15bn stock deal that would create a mega-utility with about $79bn in assets and 7 million electricity customers and 2 million gas customers in Illinois, New Jersey and Pennsylvania. With a domestic generation portfolio of about 52 GW of capacity, including long-term contracts, the new Exelon Electric & Gas would be the nation's largest power generator and a leading US wholesale power marketer. The union has received Federal Energy Regulatory Commission (Ferc) approval and is being reviewed by other regulatory agencies.
In May 2005, Duke Energy announced plans to acquire Cinergy in a $9bn stock transaction that would create an entity with 5.4 million retail customers and revenues of about $27bn a year. The combined company would rank among the nation's five largest electricity utilities. Early this year, Duke said it intends to sell its North America power-generation assets, excluding those in the Midwest, to a unit of LS Power Equity Partners in a deal valued at about $1.5bn. About 5.28 GW of generating capacity would change hands in the proposed transaction.
Late last year, FPL Group unveiled plans to acquire Constellation Energy in an $11bn deal. Combined, the companies will have more than 45 GW of generating capacity, a power marketing function that extends from the east to the west coasts and the third-largest nuclear operations in the US.
Then, in February, the UK's National Grid agreed to buy KeySpan for about $7.3bn. A big player in the US northeast, KeySpan operates gas utilities in New York, Massachusetts and New Hampshire, as well as about 6.6 GW of generating capacity in New York.
The stage is set for more transactions, although they will probably be smaller than those announced so far. Bankrupt power producer Calpine, for example, plans to sell up to 20 of its plants by year-end. The sale of these facilities could represent just a fraction of the more than 100 GW of generation assets Cambridge Energy Research Associates predicts will be bought or sold by mid-2007.
Meanwhile, AEP's chief executive is understood to have expressed an interest in continuing the firm's expansion with the acquisition of a utility company in either Ohio or Kentucky. Some sources say Duke could announce yet another deal within the next year.
While corporate consolidation will be easier and quicker with the removal of roadblocks imposed by PUHCA and PURPA, it will not necessarily be straightforward. Ferc and the state utility commissions will have the final say on mergers and these agencies can present formidable obstacles.
In late 2004, the Arizona Corporation Commission rejected a proposal by Saguaro Utility Group to acquire UniSource Energy for about $260m. And in March 2005, the Oregon Public Utilities Commission voted down a $2.35bn proposal by group of investors headed by Texas Pacific Group to buy Portland General Electric from bankrupt Enron.
More recently, lawmakers in Maryland passed a bill that would establish a special counsel to review utility mergers. This could delay the union between Constellation and FPL by at least a year. By using permission for the merger as a bargaining chip, the legislators hope to convince the company's executives to reduce a 72% increase in electricity rates planned from July.
These remaining barriers could stem the tide of merger mania. Still, the fragmented utility sector is ripe for consolidation and mergers represent the best route to quick efficiency and earnings-growth improvements. As a result, more deals are sure to follow.