Deregulation Continues to Drive Electric Utility Industry Dealmaking

M&a activity in the electric utility industry, driven largely by deregulation, has seen a fall off from its glory days of the late 1990s, but experts say there is still room for consolidation as the industry continues to evolve. “We have seen activity slow down, but as the industry continues to go from a regulated world to a deregulated environment, there will still be m&a opportunities,” says Edward Kee, head of the energy practice at PA Consulting Group in Washington, D.C. Among the successful deals launched in the late 1990s were the $17.8 billion acquisition of PECO Energy Co. by Unicom Corp. and the $8.3 billion buyout of Mid-American Energy Holdings Co. by Berkshire Hathaway Group. Notable broken deals in the period were Consolidated Edison Inc.’s attempt to buy Northeast Utilities for $6.5 billion and the $14 billion proposed acquisition of FPL Group Inc. by Entergy Corp. “The deals that failed in the late 1990s failed on their own merits. They failed for unique reasons, and that doesn’t mean that m&a in the electric utility industry is a flawed concept or is on hold,” notes William S. Scherman, an energy attorney at Skadden Arps Slate Meagher & Flom in Washington, D.C. Scherman says that in the wake of the terrorist attacks of September 11, the Bush administration’s push for a national energy policy that would encourage domestic production and open up formerly off-limits areas for exploration and production seems especially wise. “We’re probably going to see a focus on deals that include upstream assets in a North American environment in the wake of September 11,” he states. He points to the first acquisition that was done after the attacks, Duke Energy Corp.’s $3.5 billion purchase of Canada’s Westcoast Energy Inc., as an example of the kind of deal that makes even more sense post-September 11. Vancouver-based Westcoast Energy runs natural gas gathering, processing, transmission, storage, and distribution businesses, and has an interest in the Maritime & Northeast Pipeline Project. While the deal is an example of an electric utility buying gas assets, it does support Scherman’s view that future electric industry dealmaking may revolve around securing North American gas assets that can drive electrical generation. The great majority of recently built power plants use natural gas as fuel. In addition to the advantage of being North American-based assets, the gas and electric power linkage of the Duke/Westcoast deal will be attractive to buyers. “You are going to see more deals like the Duke acquisition of Westcoast because winning in the competitive power markets business is all about having the most relevant options for trading and marketing electricity. Having gas linked with electrical generation gives you the freedom to make the most profitable power trades,” says Phil Giudice, a vice president and head of Mercer Management Consulting’s global energy practice. Giudice also notes that pressure to do deals may come from the lack of growth opportunities for utilities in the next few years. He adds that under one future scenario, energy utilities could lose up to $100 billion, or one-third of their value over the next five to 10 years. He says that regulatory solutions will not be the panacea of protection for shareholders that they once were. “With deregulation legislation enacted in 23 states, rate freezes are in place for utilities in deregulated states as well as in many other states,” he says, adding that “utilities simply will find it very difficult to increase earnings by increasing price.” However, Giudice says that arguments in the wake of September 11 that the U.S. must be energy independent of the rest of the world, while understandable, don’t stand up. “Like it or not, we operate in a global economy that depends on foreign suppliers and purchasers for our goods and services, and that isn’t going to change.” But terrorism is a recent influence on dealmakers’ choices. The ongoing deregulation of the electric utility sector has been the driving force for much of the deal activity in the last five years. “M&a activity grows out of deregulation, and as deregulation has slowed down, we’ve seen a decrease in the number of power deals,” Kee says. The failure of the deregulation of the California wholesale power market, which has led to the bankruptcy of Pacific Gas & Electric Co. and the threat of Chapter 11 for Southern California Edison Co., has had a chilling effect on the deregulation process. These companies, the state’s two biggest utilities, sold off generation plants under the state’s deregulation plan. When wholesale power prices began to rise in May 2000, retail price caps left them unable to pass rising wholesale costs on to consumers. Before the California crisis about half of the nation’s states had taken steps toward deregulating their wholesale electrical industry, but now many have put deregulation plans on hold. “It’s clear that the pace of state-ordered restructuring has slowed because of California’s self-inflicted restructuring debacle. This doesn’t mean there won’t be a lot of activity in the next few years, but people are going slower,” Scherman notes. Despite the linkage between the pace of deregulation and the realignment of assets, the latest electric utility deal was inspired, in part, by the slowdown in deregulation. Utility boosts its share in nuclear power In late September Reliant Resources Inc. said it would buy Orion Power Holdings Inc. for $2.9 billion. Orion, formed in 1998 as a partnership of Goldman Sachs Group Inc. and Constellation Energy Group Inc., was set up to acquire generation assets that were coming onto the market as deregulation took hold. But with the slowdown in utility deregulation caused by the California crisis, sales of attractively priced power plants and other assets have dried up. This was one factor that led Orion to consider Reliant’s offer. One of the most dramatic reshufflings of power plant assets has occurred among the nation’s nuclear power plants. In the Peco/Unicom merger, Peco was able to add Unicom’s 10 nuclear plants to its five units, resulting in a nuclear power-generating giant that controls as much as 20% of the United States’ nuclear power capacity. Giudice notes that early nuclear power plant deals were particularly attractive because “it was cash positive to acquire a nuclear plant.” Scherman says the multiples will increase greatly. He cautions, however, that further m&a activity and the ongoing viability of the nuclear power generation industry will depend on finding a solution to the problem of nuclear waste disposal. “If Congress and the administration want to encourage the rebirth of nuclear generation, they’re going to have to deal with the problem of disposing of spent nuclear fuel,” he says. In addition to nuclear power-inspired m&a, Kee says that there might be a move to separate out retail distribution from other parts of the industry. Much of the restructuring that has grown out of the deregulation of wholesale electric power markets has separated the generation aspects of the industry from those responsible for transmission and distribution. In most cases, the task of servicing retail customers has remained with the companies that specialize in transmission and distribution, the so-called “wires” companies. Kee says that one source of industry restructuring going forward might be the splitting off of the customer interface into separate companies. While the pace of deregulation will continue to be a prime force in industry realignment and consolidation, Kee adds that companies all across the electrical industry spectrum are experimenting with different forms and trying to find niches to exploit – all of which will likely contribute to deal flow.