Pricey Premiums

The last 12 months in Europe has seen a great deal of merger and acquisition activity between players great and small. Keen to reap the benefits of consolidation, some companies are paying high premiums for acquisitions, but the benefits for investors are uncertain.

Figure 1. Electricity consumption in Europe
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Since the European Union electricity directive came into force 16 months ago, mergers and acquisitions (M&A) activity in Europe has increased dramatically.

Under the European Union directive, all member states should, by now, have opened at least 26 per cent by volume of their electricity market to competition. The directive goes no further than requiring that a minimum of 33 per cent of each national market to be open by 2003. This is equivalent to all customers across Europe who consume more than 9 GWh/year being able to choose their electricity supplier.

While some member states have embraced deregulation wholeheartedly and others have almost resisted, it is expected that all markets will eventually move to full liberalization, although this is not required by the EU directive. In fact Germany leapfrogged all of Europe by opening its markets to full liberalization in a “big bang” in 1997.

Figure 2. Regional markets within
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Pre-liberalization, the typical European power company had a legal monopoly to supply customers in its geographic region with electricity. As a consequence, these companies either built power stations to meet their own demand or entered into long term supply contracts for the provision of power by third parties.

Liberalization in itself would not have had much impact but for the requirement by the EU directive for third party access (TPA) to transmission and distribution systems allied to forced separation of financial accounts between generation, transmission, distribution and supply. This means that captive generation or supply contracts cannot be cross-subsidised by transmission fees. The disintegration of the companies’ financial reporting has given higher quality information to regulators when calculating what tariffs to set for the monopoly elements of the supply chain.

In addition, the adoption of monetary union by the core of European countries will make the job of the regulator much easier as it will allow a direct comparison of costs across a large number of companies and regions.

Figure 3. Polyethylene market prices
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Today, companies cannot assume that they will have a fixed market share and so they are unwilling to enter into very long-term contracts with generators. As a consequence of liberalization of the industry, the profitability of the electricity supply companies is under pressure.

Cost pressures grow

Growth in electricity demand in the core of the EU is low, and in eastern European countries, where forecast demand has a high growth rate, it is from a low per capita demand base. Also across Europe, there is significant overcapacity in generating plant as a hangover from the days of the monopoly supplier’s public duty requirement to ensure continuity of supply.

If growth rates were high then the overcapacity in the market might be absorbed in the near future. However, low growth implies a long period of overcapacity and in competitive markets this would imply prices equivalent to the short run avoidable cost of plant on the margin.

Growth in the market will not, therefore, relieve the cost pressures of market players. In such a situation, economies of scale can be achieved by mergers and acquisitions, and intense M&A activity has been witnessed across Europe in the past year.

There are two problems facing the European power markets in pursuing M&A. The first is one of regulated industries where any premium paid in an acquisition or merger of companies is difficult to recapture. Regulators often ask for a share of any cost benefits from the merger as the price for their agreeing the deal. As a consequence, regulated industries often have sub-optimal structures in comparison to their free market sisters.

The other problem is that the electricity market is not mature. Structures and patterns of assets have been developed over the last one hundred years to suit a completely different system and economic model.

In many cases, as the example of the acquisition of Tractebel by Suez Lyonnaise des Eaux demonstrates, a high premium over existing share price was paid by the buyer to gain control.

It is hard to justify premiums paid on the basis of operational cost reductions where assets are located in the same region. When the assets are in different countries, the opportunities for operational cost reductions are significantly reduced and strategic considerations appear to be the major justification for merger. This picture of strategic positioning becomes more apparent when smaller deals are also considered.

In its recent failed bid for Spanish electricity utility Hidrocantabrico, TXU Europe stated that it would be unable to justify to its shareholders and to those of Hidrocantabrico, the premium required to top the counterbid for Hidrocantabrico made by Union Fenosa.

Airline analogies

Some commentators are saying that these mergers are driven by a near panic reaction to the liberalization of markets. However, another view could be that the utility industry in Europe is simply following the airline industry in forming global alliances. For example it might be possible to envisage mergers and consortia forming on a European basis as the airline industry has sought to do on a global basis.

In the case of the airline industry it is believed that an airline that can offer the largest network of routes across the world would have a marketing advantage. However no airline offers a truly global reach.

Initially the alliances were between regional companies and international carriers. The alliance enhanced the offering of the regional airline and helped the international carrier to fill its aeroplanes. More recently, the size of alliance partnerships has increased and the BA/American “One World” offering demonstrates how far this concept has developed. If BA, or American, had tried to build an airline of the size and reach of ‘One World’ it would have been very expensive in acquisition premiums or greenfield growth investment and would have taken a long time.

By forming an alliance, BA and American get all the benefits of marketing scale, retain their loyal customer bases and national characteristics. One stage further would be to adopt the model of the ultimate alliance that exists in the oil industry in the form of the Royal Dutch Shell Group. Here two separately quoted companies operate their assets as one business.

The key difference between an alliance and an acquisition is that one usually requires the payment of a premium and the other does not. However in much the same way as product swaps in the oil industry are negotiated, the different value to the customer provided by each of the parties to the alliance results in different value contributions.

Risky business

Before the EU Directive came into force, power systems were operated on a national basis and, by and large, the power flows between country systems were for emergency back up or to compensate for seasonal variations in hydropower-dependent countries. The use of Austrian hydropower in Germany is an example of this. Only in the case of Italy was there a definite decision to source a significant proportion of power from outside the national boundaries. In France a decision to concentrate on nuclear power was due to a wish to be energy self-sufficient and a lack of indigenous hydrocarbons.

A review of interconnector capacities between national markets and the ability of power to flow between countries indicates that there are likely to be around seven physical markets in Europe. Transmission constraints between Iberia and mainland Europe, for example, restrict the amount of trade between these two regions and divides the European market.

Unless interconnectors are reinforced, therefore, it is likely that each of these markets will have their own wholesale electricity price market dynamic. If the markets are competitive, a pattern of pricing similar to other commodity markets might develop. An example of a competitive commodity market is polyethylene and as the graph shows there is a strong correlation to global capacity utilization (operating rate) and price.

In the case of chemicals, such as with polyethylene, a global market exists, but for electricity this dynamic might occur in each of the European zones. As the price profile is a function of capacity utilization, it is timing of new construction in each market that will determine the price profile, rather than utilization in other regions. If this is the case then a company in Iberia might be enjoying a peak in the Iberian electricity price cycle, and be making profit, when a company selling in the central zone is trading at short run avoidable cost.

The expectation of such regional pricing zones can lead to cross-border M&A activity. If a company has assets in different regions subject to different price tracks the volatility of its annual income will be dampened through the portfolio effect. Of course investors can achieve the same result by investing across a range of regional European power companies. It is, in theory, unnecessary to have financially consolidated entities.

In addition, financial theory does not take into account the practicalities of running a business. It is very difficult to develop investment plans if the company has little idea of how much cash it will have in the future. Financial institutions can be used to provide loans in the lean years, but of course there will be uncertainty over how long low prices will last. In the Nordic region today, successive wet years have depressed prices below long run average for longer than anyone has expected. But how much is smoothing cashflows worth in terms of acquisition premium?

It is recognised that the cost of capital that the market charges a company will increase dramatically if returns lead to the threat of bankruptcy. If by reducing the financial risk of its equity by half a per cent, a $5 billion (a5.5 billion) value company could afford to pay a premium of $250 million for an acquisition.

Tractebel, like other national utilities, has long made the public statement that they intend to expand abroad to make up for expected loss of market share at home brought on by competition. If a company is expecting to lose market share at home then it will need to cut costs and overheads unless it can replace this volume.

New entrants

Other considerations may drive up local and international acquisition premiums. There has not been a significant entry by non-industry players into the electricity industry. At the retail end of the business a few outsiders, principally from other utility areas, have competed to supply customers, but at the asset intensive end the action has been between existing players.

The experience of market liberalization in Europe has been that the majority of small customers do not switch suppliers even when given the opportunity and significant price incentives. As a consequence, the cost to a new entrant of acquiring a customer can be very high due to the sheer effort of reaching them and then persuading them to switch.

Faced with highly volatile wholesale prices, ownership of the customer is one route to protecting income. Acquisitions by generators of distribution companies can be seen in this light. In the early days of market liberalization in the UK, distribution companies signed long term power purchase agreements on the back of their franchises. More recently generators have been buying distribution companies or their former franchised energy supply businesses in order to gain control of retail customers. The prices paid do not appear to be supported solely by expected profit from the supply business.

However, if a generator sees itself losing significant value through competition reducing prices at home, it might be tempted to beat the market’s understanding and give the value away to investors in an acquisition premium. In this way its volumes, if not its value, are protected.

Power generation in Europe will lose value and excessive acquisition premiums are just one way this might occur.

There are a number of reasons companies might decide to merge, and some will pay high premiums to achieve this. However, evaluation of the financial impact of the downsides to the threats companies face do not appear to justify the high premiums being paid.

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