If the UK energy regulator gets his way, the creation of National Grid Transco will have little impact on the UK’s energy markets and will generate meagre cost savings. So why the merger?

UK-based international networks operator National Grid announced in April that it has agreed the terms for a merger with Lattice Group, the UK’s gas transmission networks operator. The

The new company will be called National Grid Transco and will have some 30 000 employees around the world, mainly in the gas and electricity transmission business. The merger is expected to be complete in autumn 2002 following regulatory approvals in the USA and the UK.

On completion of the deal, National Grid shareholders will hold 53.7 per cent of the company and Lattice shareholders 42.7 per cent. The new company will have debts of around

National Grid Transco’s core business will be the ownership and operation of the high voltage electricity transmission network in England and Wales and Great Britain’s natural gas transmission network. With the elimination of duplicate head offices and other central functions in the UK, the merged company is expected to see cost savings of £100m one year after the merger.

National Grid and Lattice believe that further savings from the progressive combination of their businesses will also be possible. However, it will not have escaped the notice of most in the industry that the majority of cost savings made will be passed on to customers at the behest of Ofgem, the electricity and gas market regulator, at the next price reviews. Indeed, National Grid points out that due to the merger, it will now be able to exceed the regulator’s targets for the current price review period, achieving a 30 per cent reduction in controllable costs compared with its previous target of 20 per cent.

The next price reviews will be therefore be tough, and the two companies will gain little from operating together in the UK market.

Ironically, however, it is operating in this tightly-regulated environment that has heped make National Grid into the success that it is today. Forced by the regulator to achieve high operating efficiencies, National Grid has developed asset management skills unrivalled elsewhere in the industry. It has been able to transfer these skills to international operations, where less stringent regulatory environments allow profits to be made.

In 2000, National Grid made the USA its key target market. It bought New England Electric System (now National Grid USA) for $3.2bn (€3.6bn), and Eastern Utility Associates for $634m. It also bought Niagara Mohawk, a utility based in Syracuse, New York, for $3bn. The company now derives some 60 per cent of its revenues from its US operations.

National Grid is keen to continue its expansion following its successes in the USA, but believes that few opportunities exist in Europe due to the reluctance of countries there to create independent grid operators. The fragmented market and regulatory framework of the USA, however, present it with numerous opportunities to earn attractive returns, says National Grid.

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However, further expansion through major acquisitions would be financially difficult for the company. In addition, US transmission operators often own both gas and electricity networks, and National Grid has little experience of the former.

Its takeover of Lattice will therefore create a company with the financial strength to make large acquisitions as well as the skills to operate in both electricity and gas markets. Both companies also have experience of the telecomms market but are likely to sell Lattice’s UK fibre optic business following National Grid’s unhappy encounter with Energis.

The new company will have a stronger financial base, with improved cash flow and the ability to raise debt. It will be of a size to rival European giants such as E.ON, Electricité de France and RWE, many of which are looking at the USA as a target market.

The new company is likely to continue its focus on the northeast USA. Analysts believe that National Grid Transco will be able to fund a series of billion-dollar acquisitions over the next few years. Potential acquisitions include Northeast Utilities, Energy East and Nstar.

The deal therefore makes sense for National Grid as well as Lattice, whose business operations are currently set firmly on UK soil. However, the deal could throw up regulatory issues in the UK.

Ofgem has so far said that it agrees “in principle” with the deal, and it will probably welcome the cost savings that the combination will bring. But the merger will mean that one company will be in charge of running the UK’s gas and electricity transmission networks, and this raises questions over security of supply as well as market power.