Both growth and M&A activity in the power sector are picking up again, according to PWC’s latest utility survey, but this time caution is in the air. Investors have an eye on climate change legislation and are focusing on home and regional markets rather than developing global strategies.

Nigel Blackaby, Features Editor

Investment in the world’s utility companies appears to be largely back on track, after a few years in the sidings. PricewaterhouseCoopers’ (PWC) 2005 Global Utilities Survey reveals record levels of merger and acquisition (M&A) activity with deal making running at $123 billion in 2004. The $26.1 billion purchase by Exelon of Public Service Enterprise Group (PSEG) in the US may mark the return of the mega-merger. The M&A market has undoubtedly been buoyed by continued interest from financial players who have been active buyers of generation assets, but this time around investors are likely to be a lot more cautious.

History may well view the post-Enron effect of tumbling utility credit ratings and a moribund US economy as a blip in an otherwise general pattern of growth. “The nature of how companies respond mean there are always going to be ups and downs and stops and starts but globally the energy demand factor is outstripping GDP. Combined with new sources of energy like LNG and longer supply chains this translates into a big growth demand for energy,” says Mark Hughes, European leader, utilities corporate finance and recovery at PWC.

Figure 1. Investors’ view: Where do you expect most corporate activity in the next few years?
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Certainly the demand for more energy and other utility services is there. Meeting projected supply needs will require an investment of $12.7 billion in power generation, transmission and distribution and gas supply infrastructure in the period to 2030, according to the International Energy Agency’s World Energy Outlook 2004. This report argues that, assuming governments stick with the policies presently in force, the world’s energy needs will be almost 60 per cent higher in 2030 than they are now.

An appetite for corporate growth may have returned but it is not rapacious enough to meet all the investment needs. Meanwhile utility leaders are sounding distinct notes of caution. While deregulation is seen by the majority of investors as helping the investment climate, more than a third of the 108 utility and utility investment companies across 36 countries who responded to the PWC study said that market reforms are damaging confidence. The dangers of inconsistent regulation, energy, tax and environmental policies are highlighted as a major influence over decision making.

Regional ambition

A significant characteristic of current deal-making activity emerging from the PWC study is a new approach towards geographical spread. As organizations with high fixed capital costs, utilities can often achieve better management of their risks by spreading them geographically. Companies look to acquire assets that will give them balanced portfolios and enable them to hedge supply and price risk effectively. “There is a recognition that it is difficult to make the stand-alone generator business model work,” says Hughes.

Companies are continuing to move out of their home territories in the pursuit of scale but the main focus is on their wider regions rather than a globally stretched footprint. Hughes explains: “It is necessary to have a firm, well integrated footprint in a region if you are going to compete effectively. You just can’t achieve that globally unless you are big enough to build that type of footprint everywhere.” Responses to the survey indicated that, while scale for competitive advantage is seen as more important than a year ago, expansion outside of home territories is less important. Indeed, geographical diversification was not regarded by investors as an important driver of corporate activity over the next few years.

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Undoubtedly, many large utility companies are still smarting from their global strategies of the recent past. Led by Enron, several US energy firms acquired interests in foreign countries during the 1990s only to have to sell them in a hasty attempt to shore up their balance sheets at home. Although investing in foreign energy enterprises did not in itself lead to the failure of a number US utilities, the strategy left companies exposed and unable to respond quickly to changing circumstances and such an aggressive policy is unlikely to be employed by utilities this time around. Instead the mantra is ‘back-to-basics’, shedding risky businesses and reducing debt. Divesting assets to focus on core assets has continued to be an important underlying spur for activity and much of this has meant a return to a territorial core, particularly in the case of US companies. Investors told PWC that ‘delivering focus on core business’ is the lead imperative driving corporate activity. But interestingly it is not the losses experienced by US-based entrants in Europe in the early 2000s that are preventing investment but the instability of markets, political considerations and the lack of investor transparency.

The switch to a more regionalized approach to business activity is far from just a US phenomenon. PWC’s report states that 76 per cent of respondents from utility companies in the Americas and 83 per cent of European respondents intend to stay focused on their ‘home region’. Across all regions, only a minority of utility companies are eyeing expansion outside their broad continental boundaries.

Eastern promise

Within this new regional focus there remains significant wider ambition. In the case of Europe, considerable activity is set to be directed towards eastern and south-eastern Europe and some former Soviet Union countries. Behind this strategy is a desire to secure future gas supplies and to build a presence in reforming markets.

While Europe looks towards its eastern region and America is largely looking inwards, it is the Asia Pacific utilities that are demonstrating the greatest global ambition. Nearly half of the utilities in this region that took part in the PWC study said they would be prioritising growth outside the Asia Pacific region in the next five years. Much of this will be in the neighbouring Middle East but almost a quarter of Asia Pacific respondents are lining up expansion further afield in the Americas and Europe. “It is difficult to generalize about such a vast region but as a younger, faster growing market there are more benefits to joining up with neighbours and with such a demand for new investment less risk of displacing others in doing so,” says Hughes.

Despite this it is European countries that are regarded as having the leading global utility players with EDF, EON and RWE taking the top three positions as far as both investors and utilities are concerned.

Europe again comes out as the most attractive destination for utility investors as a result of market opening and the emergence of eastern European economies. Liberalization is also playing a part in some Asia Pacific countries but the dominant force here is the growth potential that flows from the exploding demand for power in the region. PWC believes that the sheer scale of the opportunity in Asia Pacific makes it attractive for investors, in spite of structural, regulatory and political risks. Regulatory uncertainty has shaken investor confidence in the Americas although a lot of activity is anticipated through the consolidation of numerous small and medium-sized companies.

PWC argues that the trend towards regionalization is likely to lead to the emergence of strong ‘super regional’ players in the main markets around the world. Already in Europe there are companies presenting this characteristic, some that also retain global ambitions. This will develop further as European footprints spread east. In the US the scope for consolidation is considerable and PWC sees the trend emerging elsewhere as markets become more congruent and liberalization dilutes the influence of legacy national structures.

Fuel forecasts

The PWC report also reveals the expectations of utilities as to future fuel mix and investment requirements. It points to the variety of new factors that are influencing an already complex decision-making process: ever greater distances between supply sources and end-markets, vulnerability points along key supply routes, political and environmental views on nuclear and wind power and the effect of climate change levies, emissions trading, carbon prices and renewable incentives. Given all these influences, it is striking that utilities expect their fuel mix to be very similar in ten years time as it is today. “The results reflect the length of time it takes for the fuel mix pattern to change. We would expect to see some movement in the merit order, influenced by climate change regulation,” commented Hughes.

The utilities that responded expect that more power will be coming from renewable energy sources in ten years, but the overall increase in electricity demand means that the percentage will actually only rise one percentage point from 18 to 19 of the overall fuel mix. Similarly, while coal will command a smaller percentage of the market (20 per cent down from 25 per cent), the actual volume of coal fired capacity increases. Gas will account for 40 per cent of generation in 2015, up from 35 per cent, in the view of the utilities.

Nuclear remains

Utilities worldwide ranked nuclear power low with only eight per cent expecting to increase their own company’s new nuclear build programme. The broader picture was different, however, with over half of those surveyed believing that climate change would lead to an increase in nuclear power in their region. The expectation is that nuclear power will still represent around 12 per cent of utilities’ fuel mix in a decade’s time, implying that new build will take place, not only to cope with increasing demand but also to replace plant due for decommissioning “The responses on expanding nuclear may well have looked different had we been asking people to consider a longer period,” says Hughes.

Out of the OECD countries only France, Finland, Japan and Korea are currently planning to increase nuclear power in a significant way and many countries are phasing out their programmes. Nuclear’s political standing varies widely around the world and despite its re-emergence on the political agenda in some countries, any decisions to proceed with new nuclear capacity would take at least a decade to implement.

The factor most expected to influence the role of nuclear power and the fuel mix overall was climate change regulation. Although not a factor influencing geographical investments, 87 per cent of utilities think it is already having an impact or will have an impact on fuel choice. Most believe that the impact would be to boost renewables and natural gas capacity.