Merger mania

Consolidation in the European utility market is on the rise, with several major mergers between ‘super-regional’ players on the cards. High fuel prices and security of supply concerns are the main drivers, with the latter likely to lead to stronger links between European and Russian players in the near future.

Mark Hughes, PricewaterhouseCoopers, UK

The mergers and acquisition (M&A) activity in the global electricity and gas industry is entering a new blockbuster deal era. Last year was a record breaking 12 months with total deals numbers averaging four a week – one power deal for every day of the working week with just a pause for breath on Fridays. New records are being set for the total number of deals, the value of a single deal, the number of mega deals only to be trumped by the next new round of activity.

It is a dynamic time for all those involved in the power industry but the major focus of deal activity has moved firmly back across the Atlantic to Europe. Much of the recent global deal activity has been fuelled by the value of European power assets changing hands making it the power base of power deals.

Figure 1. Deals by continent
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But what are the forces behind this extraordinary activity and what are the prospects for it continuing?

Driving forces

With all EU country markets set for full liberalization by mid-2007, utility companies are moving fast to consolidate in advance of complete customer choice. Bigger businesses can get cheaper procurement and land bigger and better upstream fuel deals, which in a world of increasingly scarce gas, can be a key competitive advantage. The value of all deals for European electricity assets trebled over 2005 (up 202 per cent). The leap was even more breathtaking for purely domestic deals where the value of European electricity assets targeted rose fourfold. Excluding last year’s extra-ordinary NGT divestments and this year’s GDF privatization, the value of European gas assets in play rose slightly by 4.4 per cent.

Deal growth in 2005 was boosted by the timing of three big privatizations – EDF, GDF and Enel, but even when these are removed, along with the 2004 phase of Enel privatization, the value of European power assets in play rose 144 per cent, from $39.2 billion to $95.5 billion. Much of the running came from within the sector rather than outside parties and consolidation activity was most concentrated in two areas – France/Italy and the Nordic countries, both of which provide natural regional groupings in terms of wholesale trading markets.

However, Gas Natural’s unsolicited move for Endesa, an electricity company twice its size, crowned the year’s activity and set a new record for a single deal. A few years back, it was the other way around as Endesa eyed up Gas Natural. Gas Natural is Spain’s main importer and distributor of gas while Endesa controls about 40 per cent of the Spanish market in electricity generation and distribution. Like many deals of its size, the move could yet spark further asset sale activity. Indeed Gas Natural included up to €9 billion of Endesa asset sales, pre-arranged with Iberdrola, Spain’s second-biggest generator, as part of its bid, although, this pact has had to be modified in the light of asset sale requirements eventually imposed by the Spanish regulatory authorities as a condition of takeover clearance.

Figure 2. European electricity deals
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French utilities group Suez, which already owned 50.1 per cent of the capital in its Belgian neighbour, Electrabel, moved to buy all the remaining shares in a $13.9 billion deal. Similarly, EDF resolved long-running uncertainty over its stake in Edison, Italy’s second largest electricity producer, in a $10.3 billion deal which saw the French company team up with Milan utility AEM to purchase a controlling stake from holding company Italenergia. The move reflects the ambition of EDF to expand through growth in Italy and Germany. Elsewhere, E.ON was an active buyer of gas storage assets and moved upstream to secure supplies with the purchase of 15 North Sea gas fields from Caledonia.

But for two of these big deals, 2005 announcements may well be overtaken by events in 2006. Enel has declared it was interested in GDF and may well be interested in taking an interest in the newly merged Suez-GDF business or some parts of that new combine. E.ON has put in a big €29 billion bid for Endesa, potentially spoiling Gas Natural’s ambition to become a big converged gas and electricity operator in the Iberian market.

Private equity moves in

While industry players are grabbing the mega-deal spotlight, an equally strong current in the wider electricity and gas deal market is coming from the heavy involvement of financial institutions. The big privatizations in France and Italy of EDF, GDF and Enel attracted many pension and insurance funds but more significant is a continuing increase in generation and network asset purchases by financial players. It is financial institutions and the continued emergence of new infrastructure funds investing in the industry that are providing the main motor for cross-border activity.

A further example of the active role of financial players is the $1.8 billion purchase of E.ON’s Ruhrgas metering business by UK private equity investors CVC, one of the largest recent cross-border gas deals. It followed CVC’s 2002 acquisition of high voltage networks in Spain highlighting the keen interest of funds for the predictable income and potential for long-term capital growth that come from infrastructure assets.

Figure 3. European gas deals
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Australia’s Challenger Infrastructure Fund swooped to make an $838 million purchase of gas transportation business Inexus in the UK. Macquarie Bank advised Challenger and is a key player in the rise of infrastructure funds. This Australian investment bank is becoming a notable global and thus European mover in the power market with the acquisition of network and some generation assets for inclusion in investment portfolios. In 2005 Macquarie Bank completed the purchase of renewable generation assets in the UK and Germany and the Macquarie European Infrastructure Fund bought a 49 per cent stake in NRE Holding, a Netherlands based operator of gas and electricity distribution networks, as well as renewable assets in France.

Generation assets also featured strongly in purchases by financial players, again reflecting the potential for predictable income and capital growth; as exemplified by the $588 million move by Australian investment bank, Babcock & Brown for the wind and hydro generation interests of Portugal’s Enersis.

Authorities react

The surge in consolidation deals is also attracting the attention of the competition authorities, who have already declared their unhappiness with progress on implementing EU Directives to increase the competitiveness of wholesale and retail energy markets and enable customers to access a choice of supplier. In addition to the usual divestiture remedies required of merging companies where the EC deems there would be anti-competitive consequences, requiring third party access to infrastructure and sales of power and gas through auctions, are moving centre stage. A number of European companies including Electrabel, EDF, GDF, E.ON, Elsam and CEZ have chosen this method to sell virtual power generation or gas.

In the virtual asset auctions scheme:

  • The seller retains ownership of the assets and thus preserves its future options
  • A well-designed auction mechanism allows several bidders to win assets at the same price. This helps preventing the winner’s curse, where the winner is perceived by peers and shareholders as having overpaid
  • From a seller’s perspective, a well-designed auction mechanism helps deliver appropriate value for the assets
  • Where the asset disposal is triggered by a decision from a competition authority, a virtual asset auction process can be an efficient, transparent and non-discriminatory way to implement the decision.

Accounting impact

An important element influencing deal activity is accounting standards. The development of International Financial Reporting Standards (IFRS) has introduced new hazards for dealmakers and moved accounting for acquisitions into a vital up front deal-making role from its traditional place post deal. Neglecting this can be a potential deal killer. The volatility that can come from IFRS and the potential mismatch between the risk management solution and the reporting solution has to be squared with investors. Deals that would have been considered earnings enhancing under previous regulation can become earnings diluting under IFRS and vice versa.

Table 1. The top ten
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This is particularly important in the context of businesses with significant contracts, customer relationships or licences, which sources of intangible value need to be separately recognized in purchase price allocations and which, going forward, would be depreciated over different time frames than either tangible assets or good will.

Blockbuster prices

Meanwhile, high wholesale power, gas and carbon prices are creating a new platform for deal activity, pushing up generation asset values and strengthening deal price rationales. Increased gas prices mean gas alone is not such an attractive option, bringing nuclear, clean coal and hitherto more marginal, renewable assets strongly into play. Particularly in Europe, security of supply concerns are also reinforcing the drive to diversify and acquire assets and currently competition authorities appear not to be standing in the way of big deals, again partly mindful of supply constraints.

The high power prices in Europe have been largely driven by high gas prices and high carbon costs under the European Emissions Trading System. It has had some sometimes-spectacular impacts on the value of generation assets. In the UK, the recently floated Drax coal fired generation business has been trading at a value equivalent to à‚£750/kW ($1342/kW).

This new paradigm of high fuel prices and security of supply concerns is already prompting a blurring of traditional boundaries between upstream fuel supplies and utility company operations. Looking ahead, we can expect to see a greater integration of upstream and downstream entities and as the ‘super regionals’ continue to build scale, it is not impossible that there will be an eventual return to more stretched geographic footprints.

The gold run

The run up to the 2007 full market opening in Europe is set to continue to feed consolidation momentum in the EU.

Something that presents some intriguing possibilities for the future of power deals in Europe is the courtship of Russia. The interdependency of Russian fuel sources, Western European end markets and the need for investment point to a strong likelihood of key players striking deals to secure both supply and markets. Again, a return to more adventurous geographical footprints cannot be ruled out.

Against this background, high levels of deal activity in the power sector have a distance to run. The recent coincidence of big European privatizations will not happen again but the run up to 2007 full market opening in Europe will continue to deliver strong consolidation momentum. The attitude of competition authorities will be critical in determining the extent of future blockbuster consolidation. There will also be secondary momentum, in part spurred by regulatory conditions that will flow from fall out from the current wave of deals.

The fundamentals of strong investor appetite, the importance of non-organic growth, high fuel prices, security of supply concerns and room for consolidation are pushing deals to record levels. These all look set to remain in place for some time and one thing is certain, there are more blockbusters to come in the highly-charged power deal environment in Europe.

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