Are Today's Utility Mergers Healthy?

Duke-Progress may be a trend

Ken Silverstein | Nov 14, 2011

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If the merger between Duke and Progress goes as planned, the two say that they would continue to deliver affordable and reliable energy as well as maintain investments in clean technologies. Whether this proposed mega-merger would become routine among utilities or an uncommon deal is still unknown.

The longer term prognosis suggests that power companies will continue to merge in an effort to cope with greater environmental costs, which will be the result of tougher regulations from the Environmental Protection Agency. State regulators, which have been skeptical of bigger-is-better, may change their tune given that larger enterprises would be better positioned to buy clean generation and spread the cost of compliance.

Consider the Duke and Progress proposal that could close by year-end: The Federal Energy Regulatory Commission has conditionally authorized the deal, although it has also expressed concern about the combined entity’s market power. North Carolina’s regulators have voiced similar fears. Duke has agreed to pay roughly $25 billion for Progress, with half coming in cash and half by assuming the debt. It would be the nation’s largest utility.

Regulators could be appeased by forcing the new entity to sell off power generation and to invest in cleaner generation while promising to keep a lid on rate hikes. Maintaining employment levels and agreeing to third party control over their transmission lines to increase competition may also factor in.

In the end, though, the ultimate effect on credit quality may drive the decision-making process. Credit ratings agency Standard & Poor’s says that the Duke-Progress deal could ignite a broader trend that would return the utility sector to the “A” ratings category. It would be a prototype that leads to larger and financially stronger companies that are more capable of managing regulatory risks.

“The Duke/Progress deal is the first step in our forecast that the pace of merger activity for electric utilities will pick up, both in number and the size of deals, and a smaller group of large utilities will dominate the industry,” says Todd Shipman, utility analyst with S&P.

Critical Factors

It is true that the North American power and utilities sector has gone through a surge of activity. But the number of deals has slowed as of the third quarter of 2011 when compared to what transpired a year earlier. That’s because companies have shifted their focus from eyeing potential targets to successfully integrating those that they have acquired, says PwC, in its third quarter analysis of utility mergers.

Altogether, the global consulting firm says that nine deals valued at $50 million have been announced for the three-month period ending Sept 30, 2011. That compares to 14 transactions worth $11 billion a year earlier. “Stock price volatility and debt concerns also contributed to deal slowdown in the third quarter and we believe many in-process and contemplated deals are being deferred until the capital markets settle down,” says John McConomy, PwC analyst.

If the current lull is temporary and the utility sector is destined for a new bout of mergers and acquisitions, critical questions exist as to whether that would be good for customers, shareholders and bondholders. Companies merge, of course, for a variety of reasons but the more traditional ones are to achieve synergies and to increase their leverage in the marketplace.

Bill Kemp of Black & Veatch has tried to answer the questions as to whether those pursuits are paying off. He says that the expected synergies are often exceeded, although that may take three years before they are fully felt. Consumers, though, have generally been protected from any escalating rates by their state regulators.

Indeed, as the efficiencies mount, state utility commissions are ensuring that at least half the savings flow back to customers. Meanwhile, regulators are insisting that the new utility adopt modern technologies -- something that is more feasible given that the combined entity would have better access to capital markets.

And while the company that is getting acquired may receive a premium, the one attempting the purchase could be paying an “excessive” price. “Mergers typically depress stock prices before and after close but stock performance improves 2-3 years after close, as savings are realized,” says Kemp. Within 5 years, though, stock values regress and reflect the average group performance.

The Duke and Progress merger could represent a new trend -- that larger utilities produce noticeable benefits to all stakeholders. The state and federal regulators who grant such approvals, however, are subject to immense public pressures that could slow the momentum.


EnergyBiz Insider is the Winner of the 2011 Online Column category awarded by Media Industry News, MIN. Ken Silverstein has also been named one of the Top Economics Journalists by Wall Street Economists.

Follow Ken on  www.twitter.com/ken_silverstein

energybizinsider@energycentral.com



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Comments

Regulators

Regulators always pull conessions out of the utilities wanting to merge. It may seem antithetical to free enterprise but it is the reality of two utilities that want to merge. They do so by making sure they keep rates stable for a few years. They do so by making sure they invest in clean generation. The opposite would be for them to roll over which may mean that the larger utility would have too much market power. This gets to the heart of the current national debate, which is what is the exact role of regulators in making sure things go smoothly without hurting businesses. 

How to "screw up" a merger!

"Regulators could be appeased by forcing the new entity to sell off power generation and to invest in cleaner generation while promising to keep a lid on rate hikes. Maintaining employment levels and agreeing to third party control over their transmission lines to increase competition may also factor in."

Existing power generation facilities are partially depreciated, thus commanding allowable return on a depreciated rate base. Replacement with new generation facilities, even at the same original investment per unit capacity, would increase rate base investment and return requirements, thus requiring rate hikes. Replacement with facilities with higher investment requirements per unit capacity would require even greater rate hikes.

Existing "dirty" generating capacity would likely sell at a significant discount to existing depreciated value, both because of the potential future requirement to make it "cleaner" and because of the loss of existing market to the "cleaner" replacement generating facilities. (NOTE: This presumes an abandonment of economic dispatch in favor of environmental dispatch, which would also increase rates.) 

A requirement to maintain employment levels would eliminate one of the potential sources of savings from the merger.

Appeasing regulators is not the primary role of utility management, though at times it seems that way. Providing reliable, affordable power service at a profit is their primary role.