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Better the devil you know

THE GOLIATHS of Europe's energy sector are in danger of outnumbering the Davids. Last month, French President Nicolas Sarkozy gave his support to Gaz de France's (GdF) proposed merger with Suez, reviving a controversial deal that was first announced 18 months ago, but delayed by truculent shareholders and unions – largely because the deal would result in a majority of GdF's shares falling into private-sector hands.

The €70bn ($97bn) merger puts GdF Suez, with combined power sales of over €60bn, into the same league as Germany's E.On and RWE, Electricité de France (EdF) and Italy's Enel. The new company will be the world's third-largest listed power firm, Europe's biggest gas buyer and gas seller, and the continent's largest liquefied natural gas (LNG) importer and buyer. It will be number five and number two in the European and French power-producer sectors respectively, Europe's largest gas-transmission and distribution network operator, and the second-biggest LNG terminal operator in Europe.

This is hardly consistent with the European Commission's preference for unbundling – splitting up vertically integrated companies to give competition a better chance of taking root. But Europe's energy policy remains subordinate to national energy policy: Brussels thinks in terms of the EU, but is bereft of powers to set energy policy. This power will remain in the hands of individual governments.

The GdF Suez merger has always depended on politics: it was conceived, in February 2006, as a mechanism for blocking a hostile takeover of Suez by Enel. In the run-up to this year's French presidential election, confusing messages from the two main candidates threatened to undermine the deal altogether. Sarkozy, its eventual saviour, once opposed it: when GdF was partially privatised in 2005, he said the state would retain 70% of the company, a promise he had to abandon by approving the merger with Suez. The state will retain 35.6% of the company, just over the minimum third required by French law.

After much haggling between the companies and their shareholders about who would receive what, Sarkozy himself brokered a solution: Suez will spin off 65% of its environment business, enabling what is, in effect, a merger of equals to take place.

Some analysts say the deal has commercial benefits for the companies involved. "Industrially, it makes a lot of sense," says Jérôme Guillet, director of energy at Dexia, a bank. "It's a fairly clean merger that gives the company a good spread of activities." Global Insight, a consultancy, says it should help both companies, providing GdF with a new batch of power-generation assets – and, with them, a new growth opportunity. Suez, meanwhile, gains GdF's gas-market purchasing power and gas infrastructure. Datamonitor is less convinced of the deal's merits, arguing that power and gas integration does not necessarily boost operating profits and margins.

But all agree that scale is a deterrent against a hostile take-over. This should ensure the French state, albeit with a reduced share of the combined group, retains an important voice in one of Europe's largest energy firms. And by the same token, the companies will have a powerful state as a large shareholder. This is not a popular idea with the European Commission and some senior Suez executives are understood to be unhappy with the prospect of overbearing state influence. But in the prevailing political climate – where energy supply is seen increasingly as a question of national security and less as a purely commercial one – this may prove an advantage.

"The two companies probably think they are better placed in the European market if they have state support," says Christian Egenhofer, senior research fellow at the Centre for European Policy Studies. Jean-François Cirelli, GdF's chief executive and the future deputy head of GdF Suez, certainly seems to think so. "Energy is a strategic sector for all states. Nowhere are governments completely absent from the energy sector," he said shortly after the deal was announced.

While the companies and the government may profit from the merger, local competition may also benefit. GdF Suez will present a new competitive threat to EdF in France's power market, for example. GdF has 10 million customers to whom it can offer electricity using Suez's infrastructure. Increased size and wealth – and a liberating lack of debt – should also give GdF Suez greater penetration in other markets, potentially generating more competition elsewhere.

However, in the longer term, there are legitimate concerns about how the formation of European champions will affect competition and about the merits of such deep government involvement in supposedly privately run utilities. The continued dominance of a small number of large companies makes it difficult for new entrants to break into the business.

Earlier this year, Neelie Kroes, European competition policy commissioner, said many of Europe's energy markets are characterised by a "high degree of vertical integration". Incumbents tend to view their networks as "strategic assets that allow them to exclude competition through discrimination".

The bundlers' power is growing

However, the GdF Suez merger illustrates the difficulty – to put it mildly – that the Commission is having in winning its argument for unbundling. Indeed, in contrast to the Commission's vision of a large number of unbundled utilities, a politically backed oligopoly is emerging: a bunch of bundlers whose power is growing not diminishing.

Brussels refuses to go quietly. Last month, in its third package of proposals for the energy sector, the Commission again identified unbundling as an important step in the continued liberalisation of the EU's energy markets. But, once again, France and Germany, knowing that such proposals threaten the existence of their national champions, rejected this.

Given such trenchant political opposition, the EU's plans are unlikely to be passed by the member states. Aware of this, the Commission wisely offered a compromise: tougher regulation of integrated companies.

This might yet work. But complicating the issue further was a new clause that the Commission added to its latest energy package that implicitly addresses the EU's Gazprom problem. Foreign firms wishing to buy control of assets in the EU, proposes the Commission, will be permitted to do so only if reciprocal arrangements are in place in their home countries allowing EU firms to do the same. This could prevent Gazprom from buying downstream assets. But it is hard to see how it could stop the Russian company from increasing its influence in the EU's markets through joint ventures or other bilateral agreements.

It will also – certainly – antagonise Russia. And it may widen divisions within Europe, pitting countries that have chosen to work closely with Russia against those that have not. Such opposition could threaten the progress of the energy package, which would be a shame. The last thing the Commission needs is to give its opponents and saboteurs more motivation to keep behaving badly.

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