Utility Merger Mania?

SOURCE: US EIA Annual Energy Outlook

Standard & Poor’s Ratings Services said this week that it expects to see more mergers between investor owned utilities after Duke and Progress Energy “hooked up” following the recent announcements by Northeast Utilities and NStar and First Energy and Allegheny.

These combinations made sense because the service territories were adjacent; they could realize synergies from merging their overhead, back office and maintenance operations as well as reduce the ranks of management layers.  The premiums were modest and none of these mergers seems likely to face the wrath of customers, stakeholders or regulators.

Todd Shipman of S&P said the rating agency expected to see “25 in 5” as in twenty-five utilities mergers in the next five years.  That is not sticking his neck out very far since there surely a significant number of utilities that would fit in the same circumstances as these six companies.

The consequences of America’s policy choices means we have largely de-industrialized our country and fuel demand for power generation has for more than a decade been a bigger driver of load growth than industrial demand.

The Real Factors Driving Utility Business Transformation. But I think S&P has the factors likely to drive future utility mergers wrong.  Mergers are more likely to be driven by:

1.      Low Growth Rates. The recession hit demand and slow economic recovery rates torment utilities and many other companies.  Utilities keep investors interested by dividends and growing share price even in a low growth environment where the costs are rising.  Mergers allow utilities that share complementary risks to reduce costs and have a better chance of improving earnings over the long term.

2.      Rising Costs. The cumulative costs of renewable energy portfolio standards, smart meters, emissions reduction, new technology and other costs is a slippery slope for most utilities because the costs are driven by regulatory and legislative mandates from which there is little escape.  Spreading those rising costs across a broader customer base and reducing the overhead and back office costs of operations is the best way to improve earnings.

3.      Regulatory Uncertainty. In addition to the rising costs of existing rules, utilities face tremendous uncertainties about future regulations affecting power generation technology, fuel choices, retrofitting existing power plants and the disruptive potential of distributed generation, demand response and energy efficiency.  For utilities with portfolios based in coal to merge with another with a portfolio driven by natural gas, nuclear or a larger renewable portfolio again spreads the risk and helps moderate the rate impacts for customers.

4.     Technology Driven Scale. While ratepayers have yet to see the benefits of smart grid in the installation of smart meters, technology is overwhelming the traditional utility and opening the door for new entrants better able to exploit technologies.  Scale is a strategy likely to make utilities both better positioned for the future and more vulnerable at one and the same time.  Gaining the benefits of new technologies requires mass deployment to drive down the learning curve costs and exploit the benefits potential.  The same factors we have seen in the information technology sectors in software, computer and network hardware and services will also push for bigger scale, broader footprints especially if here are complementary synergies for adjacency, portfolio blending or fending off hostile suitors.

5.      Foreign Direct Investment. The Chinese are coming!  The Chinese are coming!  They have a big chunk of our national treasury and need a place to spend it.  The US is still the marketplace for the world and what better place to put your money than in stable, incoming producing, dividend paying utilities.  While the EU struggles with its own economic and regulatory problems with the EU competition directives, we are more likely to see investors from Asia target the US.  Besides China the logical other big investor is South Korea looking for a market for its superior nuclear power generation technology and eager to beat China to our markets.  Who would you rather do business with?

6.      Game-Changers. This is the do you feel lucky question that keeps utility CEOs up at night.  There are such game changers that could turn the industry on its head including:

  • interstate electric transmission construction to bridge the three grids and thus enable national scale merchant generation and demand response services;
  • customer aggregation permitting commercial and industrial customers to more easily shop for energy services and engage companies like EnerNOC, C-Power, Comverge and other to provide constant energy management for all their stores;
  • cost effective energy storage is just beginning to attract investment sufficient to reduce the cost and improve the performance but if it can do so the utility world gets turned upside down.

Taken together with the prospects of slow growth, weak earnings, rising costs, uncertain regulation and large scale, deep pockets players including foreign firms willing to spend money to buy a serious market position in US markets for the next boom stage of the power business cycle and beyond and you can easily see how utility merger mania could provide the great escape for those who fear change and great opportunity for those who thrive on it.

And there is one more thing. Even the largest investor owned utility or utility combination is small relative to the size of the industrial giants investing heavily in the smart-grid enabled future.  For utility CEOs feeling the heat of change and not sure how they can herd all the cats toward defining a new utility business model to replace the one in place today tying the CEOs hands behind his back while competitors slice away at his options, mergers may not be such a bad outcome.