Liberalisation drives M&A spree
The European Commission is talking tough on mergers and acquisitions between the region's utility companies, but this will not slow the pace of deals in 2007, writes NJ Watson
LAST YEAR, like the year before that, was a record year for mergers and acquisitions (M&A) among Europe's utilities. Yet despite the ever-louder, ever-more disapproving noises coming out of Brussels, 2007 will see more of the same.
According to financial-data provider Dealogic, in the year to the end of November 2006, 334 deals were announced by European utilities worth a total $187.5bn (see Table 1). That compares with 304 deals announced in 2005 worth $123.8bn and 307 deals in 2004 worth $54.7bn (see Table 2). The energy sector has helped propel the value of European-targeted M&A to a record $1.34 trillion in 2006 – up from the previous high of $1.12 trillion in 2000 – and Europe now accounts for 40% of the value of global M&A.
Hardly a month goes by without at least one large utility merger proposal. One of the latest planned deals is between Spain's Iberdrola and the UK's Scottish Power – which has been a prime take-over target since it decided to offload its main US subsidiary, PacifiCorp, in 2005. In November of that year, Scottish Power rejected a £5.70 a share bid proposal from Germany's E.On. Italy's Enel is also reportedly interested in gaining access to Scottish Power's 2 million customers.
Iberdrola's bid for Scottish Power is motivated by a mixture of offensive and defensive reasons. Scottish Power is one of the few remaining targets left in the sector and gives Iberdrola the opportunity to expand into a large, lucrative market and new business segments. According to the French brokerage Oddo Securities, Scottish Power's growth potential in renewable energies, particularly in wind power, is an attraction for Iberdrola.
Eat or be eaten
But the Spanish company is also attempting to protect its independence; Actividades de Construccion y Servicios, a core Iberdrola shareholder, with a 10% stake, appears determined to merge Iberdrola with another Spanish energy corporation, Unión Fenosa, to form a national champion. It is a case of eat or be eaten.
The driving force behind these deals is the liberalisation of electricity and gas markets in the European Union (EU). By July 2007, all consumers in the retail and business sectors of the EU should be able to choose their electricity and gas suppliers. This new competitive environment is limiting companies' ability to grow organically, forcing many to look instead at M&A to deliver growth.
Part of the reason that organic growth in utilities is so difficult is because of the way the EU implemented its grand liberalisation project. According to Dieter Helm, an adviser to the UK government on energy policy, the EU has been guilty of forcing through liberalisation before building the interconnections between national markets that would allow competition to thrive. "The Commission put the competition cart before the infrastructure horse," he says.
Perhaps in acknowledgement of this, the Commission's February 2006 report into how liberalisation of the continent's energy markets is progressing recognised this lack of integration between the various national markets, along with market concentration, as the main impediments to competition.
The report noted that there was no significant cross-border competition, with incumbents seemingly uninterested in competing on their neighbours' territory. In the gas sector, new entrants are unable to secure transit capacity on important pipeline routes; while in electricity, cross-border trade is hampered by insufficient interconnection and long-term capacity reservations. One of the few exceptions to date has been the UK's Centrica starting power and gas marketing operations in Germany in 2006.
First come, first served
"Buying into a market is the only way to get started; every big utility knows its competitors are going to be coming into its market so existing market share has nowhere to go but down," says Anton Krawchenko, an analyst at the Datamonitor consultancy. "This creates a race – get into their market before they get into yours and keep your revenue and growth stable ahead of the inevitable loss of home market share by positioning yourself to grow in your competitors' markets."
Competition helped to bring much-needed investment to the energy industries of central and eastern Europe, but it also opened a vast new marketplace for Western utilities. They used their cash stockpiles to snap up smaller, poorly capitalised firms that were struggling to cope with the new environment of customer switching and different types of product tariffs.
The consolidation that ensued has been so swift and comprehensive that, some experts argue, the Commission was caught out. The Commission has arguably compounded this problem of concentration by continuing to approach M&A on a country-to-country basis, instead of looking at it on a regional basis.
For example, the Competition Commission is waving through the deal between E.On and Spain's Endesa on the grounds that the German company is not operating in the Spanish market and, therefore, there are no competition issues. However, analysts say Endesa could potentially become a very important competitor to E.On once the EU markets are interconnected. "The Commission has ignored the possibility of competition in the future and allowed a level of concentration that has caused a substantial reduction in the degree of potential competition," says Helm.
Indeed, the EU's six largest utilities – Belgium's Electrabel, Gaz de France (GdF), Electricité de France (EdF), Enel, and RWE and E.On of Germany – now control 43.1% of Europe's market in terms of the amount of electricity and gas sold to end-users. If E.On succeeds in buying Endesa, this market share will rise to 46.2%. A forecast that the top six utilities will hold 50% of the European market by the end of 2007 is a fairly conservative projection, says Krawchenko.
While the forces that are driving consolidation in the industry are set to continue, the conditions in which they operate might change if the Commission's recent actions and pronouncements are anything to go by.
Words of warning
In April 2006, Brussels charged 17 EU member states over their failure to fully implement measures designed to make their energy markets more competitive. This formal notice is the first step in an enforcement process that could see these countries being fined. The EU's reform efforts are also focused on a corporate level. In May, the Competition Directorate-General launched raids on the offices of 20 energy companies, in five member countries, as part of an investigation into alleged anti-competitive practices.
When faced with yet another politically driven tie-up to create a national champion, this time between France's Suez and GdF, the Commission launched a far-reaching review that ended in November. The Commission approved the merger, as long as the two companies made significant divestments (PE 12/06 p36).
The forced asset sales include Distrigaz, Suez's Belgian gas distributor; and GdF's 25.5% stake in Société de Production d'Electricité, Belgium's second-largest electricity supplier, behind Suez's Electrabel. Additionally, the partners must reduce their stake in Suez's other Belgian gas distributor, Fluxys, to 45% from 57%, and GdF must sell its heating subsidiary Cofathec Coriance.
The end of vertical inegration?
The approval of the merger followed a hard-hitting October speech by Competition Commissioner Neelie Kroes to the Conference on European Energy Strategy in Lisbon. Kroes appeared to signal the start of a campaign to end the vertical integration common among Europe's utilities by breaking them up if necessary – a radical step, but one that can be imposed on a company or group of companies as a remedy to a breach of competition law.
"Kroes' proposed solutions are clearly preliminary and much work would need to be done to convince key players within the [Commission] and among EU governments before such proposals could be adopted. Nevertheless, they give an indication that a stricter regulatory environment is a very real prospect for the near future," says Matthew Hall, an analyst at the Global Insight consultancy.
Even so, Kroes faces an uphill battle in her fight to push through radical remedies. Datamonitor's Krawchenko says that while there are powerful arguments for why networks should be independent, these integrated companies "have an arsenal of good arguments" to support industry consolidation and a continuation of the vertical-integration model.
One argument in favour of consolidation is that it gives European utilities the scale and power to deal effectively with the likes of Gazprom; Russia's gas monopoly will never be unbundled, is hungry to buy European energy assets and controls over a third of European gas supply.
"EdF has explicitly trumpeted security of supply in its defence of the vertically integrated model," says Krawchenko. That is a formidable obstacle to far-reaching reforms emanating from Brussels. "It may be [German premier Angela] Merkel versus Kroes in the battle for network unbundling; and in that direct confrontation, Merkel wins."
In addition, it is still unclear whether Kroes has the backing of her colleagues, especially the Energy Commissioner, Andris Piebalgs, who is drafting the Commission's legislative proposals on the energy market to be published this year. And, says Global Insight's Hall, "The Commission's president, José Manuel Barroso, while continuing to express concerns over the state of the European energy market, has also stopped short of officially endorsing Kroes' point of view."
It may be counter-intuitive, but forced unbundling could also lead to more, not less, M&A activity. While making network infrastructure independent will probably force private equity and infrastructure funds – which covet such assets as they provide a steady stream of revenue for leveraging the deal – out of the sector, the process will also increase competitive pressures, which in turn boosts the driving forces behind M&A.
Putting the brakes on
What might finally put the brakes on M&A activity would be for the Competition Directorate-General to begin looking at the European market as a whole, rather than at individual markets within member states. But analysts say this would require a paradigm shift in its thinking, something that is impossible to envisage happening quickly.
But time is not on Europe's side. By the time Kroes and the talking-shop that is the Commission designs, adopts and implements the measures necessary to halt this M&A surge, the industry shake-up and consolidation process will be nearing completion. "The big M&A deals will be done and all the eastern European bargains will be snatched up," says Krawchenko.n