With 35 400 MW of installed power capacity and 15.5 million connected electricity clients, Poland’s power sector was by far the largest entrant to the EU energy market in May 2004. One and a half years into EU membership, however, liberalization, privatization and consolidation remain unresolved issues.

Hopes for significant progress in liberalizing the Polish market are continuously dashed by regulatory deficits and political turmoil. Although 52 per cent of the country’s electricity market is theoretically open at an eligibility threshold of 1 GWh, only one in ten industrial customers have so far decided to switch suppliers, largely due to a lack of truly competitive alternative offers. This is primarily caused by the dominance of long-term contracts between generators and the state-owned transmission system operator PSE, which limit contract-free power supplies. Originally used by generators as bank collaterals for financing large-scale investment projects, the dissolution of these long-term contracts has been under discussion for a long time, but seems unlikely before mid-2006. Additionally, competition is hampered by trade barriers on the power exchange, an overly large market share of a technical balancing mechanism, incomplete unbundling and impeded third party access due to high network charges and the need for investment in metering equipment.

Nevertheless, liberalization has already reached the point of no return and will continue. In January 2005 the Council of Ministers approved a long term sectoral strategy plan, confirming further deregulation and stressing the need for an increase in Poland’s physical interconnection capacities with Europe. Moreover, an amendment of the Polish energy law of April 2005 clarified application rules for third party grid access and set the legal framework for further unbundling procedures in power transmission and distribution. Further legal specifications are being prepared by the energy regulator and could come into force once the national conservative government elected in September 2005 takes office.

Stalled privatization

Political decisions are also needed in the case of Poland’s stalled privatization process. After a temporary boost in 1999-2002, when RWE, EDF, Vattenfall, Electrabel and others made major purchases in generation and distribution, investors assumed a wait-and-see approach, frustrated by highly political negotiations and fearing possible losses from cancelled long-term contracts and costly staff concessions. At present, an estimated 65 per cent of power generation and 84 per cent of distribution assets remain state owned, leaving plenty of room for further privatization.

Figure 1. The progress of liberalization in Central and Eastern Europe
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According to the plans of the outgoing government, only Poland’s largest power producer BOT and the transmission system operator PSE are to be withheld from full privatization. Partial privatization, however, is planned in the case of BOT for 2006/2007. A government veto right on strategic decisions was established at PKE, the country’s second largest energy generator. Other companies are to be privatized, and bid procedures at the power plants Kozienice (2785 MW), Dolna Odra (1947 MW) and Ostrołęka (676 MW) are in progress. Government officials previously also announced the sale of minority stakes in the ENEA distribution group and PKE. The change in government in September 2005 is likely to lead to a temporary lack of decision-making in the privatization process while the potential coalition partners struggle to find a common stance on how to proceed with power sector privatization.

Asset consolidation

The next round of privatization will crucially depend on decisions regarding the administrative consolidation of Polish power assets. An initial breakthrough was reached in January 2003, when the State Treasury allowed lignite and coal mines to be merged with power plants into the two powerful producers BOT and PKE, jointly accounting for revenues exceeding 50 per cent of overall market sales. In power distribution, 31 regional companies were integrated horizontally to form six groups (Enea, Energia Pro, Enion, Energa, the Eastern Energy Group and, Ł2) with market shares ranging from 7 to 21 per cent. These changes were designed to enable synergies, lower the costs involved and improve bids in future privatization efforts, but were restricted to horizontal mergers.

Further vertical integration, i.e. the joining of generation and distribution assets, has, however, been a major bone of contention among sector representatives for the last two years. Senior executives of power producers and representatives of the Treasury Ministry argued that the pooling of both generation and distribution assets would allow companies to optimize along the value chain and so increase their investment capabilities. On the other hand, the Ministry of the Economy together with the country’s energy regulator, the anti-monopoly agency and most distribution groups feared monopolization and further delays in the liberalization process.

Figure 2. Privatization status in Poland’s power sector
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Finally, in June 2005 the Polish government approved vertical integration, but did not explicitly recommend which companies should merge with one another. Speculations abound, and tentatively point to possible BOT-Energa and PKE-Enion mergers. The country’s largest partly privatized power generator, PAK, may take over important lignite mines in Adamów and Konin. While other companies lobby for takeover scenarios at ministries, two of the country’s distribution companies, ENEA and Energa, placed a regular bid for power plants within the ongoing privatization process.

With ongoing coalition building after the September elections, the debate around vertical integration remains heated. The victorious conservative Law and Justice Party points to vertical integration preceding any ‘sell-out’, whereas the likely coalition partners from the liberal Civic Platform Party fear inefficient mergers and prefer fast privatization involving both strategic investors and the stock market. Nonetheless, consensus has been reached on the need for further privatization in principle, and discrepancies relate only to selecting the best approach for increasing company value and maximizing revenues to the budget.

Charting the curve

The Polish debate has to be seen against the background of general sector trends. Empiric evidence proves that the tendency of major industries to consolidate is inevitable. Based on a database of over 29 000 companies from all sectors, A.T. Kearney has deducted the pattern of the consolidation S-curve (Figure 3), along which the development of the concentration in main industries can be explained – and predicted.

Figure 3. A.T. Kearney’s Consolidation S-Curve and the positioning of the utilities sector
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The European utilities industry is no exception. After an opening phase of deregulation, when former monopolies were broken up in numerous companies, the concentration was a low 14.5 per cent CR3, i.e. the top three companies in the industry (EDF, E.ON and RWE) controlled 14.5 per cent of the market. By 2004, this share has risen to 40.9 per cent. At the same time, the total number of companies in the sector declined. Poland’s horizontal integration, reducing the number of distribution and generation companies in roughly the same timeframe, supports the trend described by the consolidation S-curve.

The European utilities sector is currently completing the ‘scale’ phase, during which major players are very active in snapping up acquisition opportunities in great measure. At the same time, some players are excelling in organic growth, outperforming their competitors and preparing to solidify their hard won position in the ‘focus’ phase.

According to the S-curve, the market share of the three main players is likely to reach 60 per cent within seven to eight years. As the large European players have exhausted domestic growth opportunities or have reached regulatory limits in their domestic markets, they are actively looking for growth options elsewhere. Poland is a very attractive target market, and all major players are thus either present or are trying to gain a foothold in Polish power. Essential for their success is both the political will to sell to ‘foreigners’ and the permission for vertical integration. So far, only Vattenfall has managed to buy both distribution assets as well as a fairly small part of CHP generation capacity outside its grid area. Future bids of all involved players are likely to be significantly higher if they can factor in the advantages of integrating the steps of the value chain. For EDF’s generation portfolio a distributor as a secure customer would be extremely valuable. RWE would like to invest in generation capacities to supplement its Warsaw-based distribution company Stoen. In September 2005, RWE executives declared Poland their key target market in Central and Eastern Europe, with the explicit aim to secure a share in the country’s leading generator BOT.

Consolidation vs growth

Facing takeover bids, it is in the interest of the Polish government and affected companies to increase company value prior to privatization. This requires an improvement in profitability and revenue growth, as it is growth that mainly drives share performance and hence market capitalization.

The current position of Poland’s electricity sector companies is difficult against the European background. On the positive side, some companies have increased their profitability, albeit from a low level. This was possible mostly due to modernization investment and restructuring activities. Nevertheless, comparing the small size of all Polish companies to that of their competitors in terms of market capitalization shows the huge advantage with which the capital-rich European players operate. To further grow in value, Polish utilities have to improve their revenue growth rate. With the window of opportunity closing, and investment opportunities increasingly scarce, determined action is required.

When comparing possible growth options for Polish companies such as further horizontal integration, international expansion, greenfield investments or vertical integration, the latter appears to be the most realistic and attractive choice.

In this case, prolonged state ownership might help companies become ‘value growers’ and increase the attractiveness of later privatization. Prominent examples in the Czech Republic, France and Sweden demonstrate how utility firms can capitalize on vertical consolidation and a certain degree of governmental protection in their domestic market to grow aggressively abroad.

Development scenarios

Against the background of an incoherent privatization policy and a hesitation to allow far-reaching vertical integration, three possible mid-term scenarios appear: a piece-by-piece sell-off, partial administrative vertical integration or the creation of a national champion.

The piece-by-piece approach implies a fast-track privatization without earlier administrative consolidation. It is the approach which the outgoing government tried to implement, driven mostly by budget emergencies and sparking a heated political debate, which ultimately hampered successful privatization. From a value creation point, however, this approach seems questionable. Only companies which already have a foot in the door of the Polish power sector are likely to submit relatively high bids if they hope to vertically integrate their holdings to the extent allowable under unbundling legislation. They could thus price in certain synergies and development opportunities. For new entrants to the Polish market, such upside potentials are subject to even more uncertainty. The number of high bids will thus be limited. For all possible investors, however, the uncertainties over whether they will be able to combine their jigsaw puzzle pieces to compile a well-balanced portfolio remain large, thus lowering prospective proceeds from privatization.

In the partial administrative vertical integration scenario, mergers between distribution companies and one or both of the state-owned large generation groups BOT and PKE would precede privatization via the stock exchange or sale to a strategic investor. Mid-sized, vertically integrated companies would form a significant, inherently balanced package of assets, reducing risks for possible investors and increasing prices they would be willing to pay. While unprofitable companies might be packaged with attractive assets, the advantages of economies of scale and the possibility of internal risk hedging might compensate this effect. But it is by no means certain whether the medium size of the companies that emerge would suffice as a basis for sustained value growth. When comparing the possible size of either BOT or PKE combined with a distribution company of up to 15 per cent market share with competitors such as EDF, Vattenfall or RWE, the scale of integration does not appear to do the trick. Still, given the election victory of its principal advocate, the Law and Justice Party, this approach appears more and more probable.

Only the national champion scenario would create a significant player by European standards. This would require combining BOT and PKE as well as two to three distributors into a dominant company on the Polish market, covering the value chain from mining to supply. Considering the risk of re-creating a country-wide monopolist and the associated lack of pressure to improve efficiency, it is not an advisable option in the absence of a well-established regulatory framework and a powerful regulatory agency. While such a national champion would in all likelihood be privatized via the stock exchange in several steps, full privatization should be the explicit mid term goal and a certain stake should be sold to a strategic investor in order to ensure pressure on the management to improve efficiency. Despite its political advantages, this ‘big-fish’ scenario provokes very serious concerns for the national competition authorities and seems implausible at present.

Key ingredient

On the whole, Poland is a slow mover when it comes to enabling its energy sector companies to turn into independent, viable, growth-oriented companies. As a result, foreign investors will dominate the Polish market in the long run. Nevertheless, the Polish government can still ensure that energy companies within Poland will play a significant role, if not as independent companies, then as important subsidiaries within the group structures of international players. Consolidation in the form or vertical integration is a key ingredient for achieving this. Polish energy sector representatives should thus end the back and forth, focus on the big picture and move on.