Movers, shakers and dealmakers

Dreamstime
M&A deals in the global power and utilities sector in 2012 totalled $120 billion
Credit: Dreamstime

The good times are far from rolling-in in the power and utilities sector, yet experts expect robust dealmaking this year. Kelvin Ross examines why 2012’s challenges are leading to this year’s opportunities.

Relatively robust, in an economic malaise and on life support: these are the descriptions of the economic activity in three different regions of Europe.

Exactly where they are we will get to later, but this assessment – from analysts at UK consultancy Ernst & Young (EY) – illustrates how we cannot assume that the global economic downturn has impacted Europe as a whole in one particular way.

Indeed, while the potential to do multi-million or billion-dollar business deals in some areas of the world has stagnated, in others there are ripe pickings for investors.

EY recently published its Power Transactions and Trends report, in which it looks back on the mergers and acquisitions (M&A) activity in the power and utilities sector in 2012 and predicts what it expects to happen this year.

For 2012, it initially tells us nothing we did not know already – it was a year of transformation for the sector that resulted in a tough landscape – but behind the headline conclusions there are some surprises.

And despite the economic turmoil of the last year, EY is upbeat on the prospects for 2013, forcasting robust M&A activity.

2012 value falls

Last year, M&A deals in the global power and utilities sector fell to a total value of $120.4 billion, compared to $144.7 billion in 2011.

EY states that a weak macro environment prompted buyers to focus on lower-risk transactions and internal cost-cutting programmes. While the first half of the year remained in line with 2011, the second half depressed the average deal value, with more deals under $100 million reflecting a greater emphasis on smaller deals and an increase in renewable transactions.

Joseph Fontana, E&Y’s Global Transactions Power & Utilities Leader, says the tougher landscape in 2012 was caused by “decade-low natural gas prices in North America, aggressive European environmental regulations, continued Eurozone economic uncertainty and over-leveraged balance sheets at some of the larger European players”.

Europe contributed almost half of 2012’s global deal volume and value. Divestment and privatisation programmes accounted for nearly 20 per cent of European activity as several utilities sold non-core assets to strengthen their core businesses and expand in lucrative emerging markets.

Europe was also the focus for renewable energy transactions, with wind the most active segment. While subsidy cut announcements curtailed some activity, momentum was maintained as utilities struggled to balance capital allocation and portfolio management, while complying with aggressive environmental mandates.

Last year, Europe was also the “favourite destination” for Asian investors, who were attracted by favourable regulatory policies and availability of high-quality assets.

In Asia-Pacific, major transactions in China and Australia saw the region’s 2012 deal value rocket to $30 billion from $11.3 billion in 2011.

Some $2.3 billion of this was accounted for by a consortium of pension and infrastructure funds, led by Canada’s Ontario Teachers’ Pension Plan. Meanwhile, several Chinese power companies such as Beijing Jingneng Thermal Power and Zhengzhou Coal Industry & Electric Power were active in acquiring domestic thermal electric power generation assets.

Similar trends were seen in other South Asian countries such as Malaysia, Thailand and Indonesia, where the need to meet baseload demand shifted M&A focus to securing fuel supplies.

With Europe – and primarily the UK – remaining the number one foreign choice for Asian investors, attracted by favorable regulatory policies and the availability of high-quality assets, EY anticipates more transactions by Chinese players this year, particularly since the Chinese government is pushing a strong mandate to diversify and expand globally.

In the Americas, the US became one of the most active countries for generation deals during 2012, thanks to depressed natural gas prices, while in Latin America, Brazil continued to attract foreign investors on the back of its strong economic growth and significant energy infrastructure investment needs.

Europe: sell, sell, sell

EDF
Hinkley Point C: One of several potential new nuclear UK reactors
Credit: EDF

So back to Europe and those three very different areas mentioned earlier. The relatively robust economic activity is happening in Eastern Europe, Western Europe and the UK are in an economic malaise, while it is Southern Europe which is on life support.

Yet as stated before, the region contributed close to 50 per cent of global deal volume and value in 2012. Several utilities divested non-core assets throughout the year to strengthen their core businesses and expand in emerging markets.

Austria’s leading utility Verbund sold its 50 per cent stake in Turkey’s EnerjiSA Power Generation to E.ON for $3.9 billion, in return for the German utility’s interest in eight hydroelectric power plants in Germany.

Large utilities including Spain’s Iberdrola and Germany’s E.ON and RWE featured in the majority of big-ticket divestments, and together contributed over $11 billion to the total deal value.

E.ON
German utility E.ON was highly active in divestments in 2012
Credit: E.ON

A key European deal was the sale of RWE and E.ON’s stake in the UK’s Horizon Nuclear Power project. Horizon was set up to jump on Britain’s nuclear new-build wagon – currently idling in neutral thanks to too much policy uncertainty – but the withdrawal from nuclear by the Merkel government left the two German utilities needing to pull out of the project and in turn even-out their balance sheets. Horizon was bought by Japan’s Hitachi for $1.1 billion. They are unlikely to be the last entrants to the UK market. EY states Chinese investors are continuously stepping up investments in European nuclear markets and predicts they are likely to be involved in up to five nuclear reactors being built at a total cost of $56.46 billion in the UK.

The Merkel effect

Arguably nowhere in Europe did government policy more dictate transaction trends in 2012 than in Germany.

The nuclear phase-out and a ramping up of renewable generation in a bid to hit ambitious 2020 targets prompted a spate of strategic sell-offs.

The experience of E.ON and RWE is representative of this course of action. Both saw their market capitalisation plummet following the announcement of the nuclear phase-out in May 2011. With substantial investment needed to fund the continuing transformation of the sector, they embarked on ambitious divestment programmes, with E.ON aiming to raise $18 billion and RWE $11 billion.

The key challenge for both, says EY, is simultaneously managing cost cutting, divestments and investment into renewables – mainly offshore wind – to comply with the power portfolio set out by the government.

One road to much-needed new cash for both E.ON and RWE in 2012 was the disposal of their regulated transmission assets. Both identified transmission grids, with their relatively low returns, as no longer core to the future of their businesses.

Buyers which snapped up the grids included transmission system operators in the Netherlands and Belgium, as well as financial investors and infrastructure funds attracted by the predictable cash flows of this regulated sector.

EY states that E.ON’s sale of Open Grid Europe – the company’s gas transmission grids – illustrates the international nature of these deals: the buyers were a consortium of investors, led by Macquarie and included an Abu Dhabi fund, a German insurance firm and a British Columbian investment manager.

Several regulated distribution grids also went up for sale last year, but selling these in Germany is more complex than selling transmission, notes EY, as utilities run the distribution businesses under contract with local municipalities, which in most cases must be allowed first refusal to bid.

EY states: “The average price of these regional distribution companies exceeds $1 billion, so municipalities typically need to team up to buy them, compounding the complexity of the sales process.”

As of the beginning of this year, EY said “one sale had collapsed and six were still ongoing. Infrastructure funds and pension funds have shown interest in investing in these distribution grids, but to date the contractual situation has prevented them from entering the market. In the near future we might see these obstacles disappear.”

Brazil: unsettling backdrop

In its report, EY also focuses on Brazil, where it states that the government’s bid to reform its electricity market has created “an unsettling backdrop for the country’s power markets, hindering some deals and placing pressure on energy stocks”.

Towards the end of 2012 the government announced its decision on renewals of power concession contracts expiring between 2015 and 2017, as part of an effort to lower power costs in the country.

With the new measure proposing a significant reduction in the taxes and fees that have pushed Brazil’s energy costs to among the highest in the world, EY says electricity concession owners “had to decide whether to renew their contracts for a new 30-year period. Those who do so must agree to lower, capped tariffs and are to be reimbursed for losses related to contract anticipation.”

According to the government, 60 per cent of the generation contracts and 100 per cent of the transmission lines may accept the renewal.

This, says EY, “gives concession owners predictable and longer future cash flows, but it obviously reduces cash generation for some important energy players, forcing them to rethink their strategy for Brazil. This may pressure some companies into adjusting their return expectations by selling or buying assets.

“At the same time, some assets not affected by the new rules ࢀ” especially generation contracts ࢀ” will look attractive to new investors. We may see M&A activity on the rise as portfolios are rebalanced.”

EY believes Brazil now has the chance to build “a more sophisticated market under a more predictable, lower-return regime”.

As a very capex-hungry country, the Brazilian Development Bank is currently providing most of the funding and “doing a great job above and beyond what would normally be expected”, notes EY, but adds that “the heavy demand means more routes to finance are needed”.

“Brazil is now trying to develop a bond market for participants to issue new debt, and the banks are trying to develop a secondary market for these bonds. In a recent development, Brazilian private commercial banks are starting to finance long-term contracts. The bond market is evolving to keep pace with demand.”

Renewable energy will play a key role in Brazil’s financial fortunes. Competition for government-auctioned contracts has been intense, with a large number of international players fighting it out to invest and set up bases in Brazil.

With a large number of competitive renewable energy players and a well-developed local supply chain, EY states it has “started to see generators sign power purchase agreements with off-takers outside the regulated power pool.

“This opens up a potential wealth of opportunities for investment. If the right contractual basis is established, the free market can now offer investors the confidence to provide long-term project financing. We can expect this to be a growth area into next year.”

2013 propects

Looking to deals this year, EY predicts that despite the preference for lower risk and lower-value transactions, “we will see billion-dollar deals coming out of European utility divestment programmes, particularly on the regulated side, where there is strong buyer interest”.

It anticipates further T&D asset sales in Germany, the UK and Western Europe and “a number of assets up for sale in the troubled Southern European region”.

Greek and Czech Republic privatisations are expected to move forward, while the Irish government has announced the sale of Bord Gàƒ¡is Energy.

Joseph Rodriquez, Resident, Transactions of EY’s Global Power & Utilities Sector, said: “The ingredients are in place for a steady deal-making environment in 2013. Access to credit remains relatively strong, and there is a war chest of sovereign wealth capital ready to be put to work. The valuation gap between buyers and sellers that held up some deals in 2012 will narrow as sellers act on investor pressure to redeploy capital.”

Fontana adds: “As global power and utility companies continue to operate in a fluid market, transaction opportunities will naturally follow. Whether the aim is to rebalance the mix of competitive and regulated businesses, reduce debt, focus core operations, or free up capital to invest in emerging markets, there will be robust activity in 2013.”

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