Will PUHCA Repeal Hasten Utility Consolidations?
The energy bill that President Bush signed on August 8 repeals a 1935 statute — called the “Public Utility Holding Company Act” — that makes it hard to form multistate electric and gas utilities in the United States. The repeal takes effect in early February next year.
Chadbourne hosts an annual conference for leaders in the energy industry. One topic at the conference this year was whether repeal of this statute will lead to a wave of utility consolidations. There are 3,000 electric utilities and 1,500 gas utilities in the United States. When a similar statute was repealed in 1994 that inhibited interstate banking, the number of US banks dropped from 14,000 to 7,000 in just a few years. The discussion took place in late June.
The speakers are Stephen P. Reynolds, chief executive officer of Puget Sound Energy, the largest private utility in the state of Washington, Michael Hogan, senior vice president of Centrica North America, the North American arm of a large energy company based in Britain that was created after the demerger of British Gas, Peter Rigby, director for utilities, energy and project finance for Standard & Poor’s, David Haug, formerly with Enron and now a managing director of Arctas Capital Group, and Christopher Seiple, director of global power for Cambridge Energy Research Associates. Keith Martin and Adam Wenner, two Chadbourne lawyers, participated in the discussion. Neil Golden, a Chadbourne partner in Washington, was the moderator.
MR. GOLDEN: The agenda for this panel discussion talks about 3,000 electric utilities and 1,500 gas utilities. A lot of those are probably not what we are thinking about when we talk about mergers of utilities, since many of them are electric cooperatives or municipal utilities that are not potential acquisition targets. The real volume of potential merger activity is much smaller than that.
As to the banking analogy, my own view is that banks are a good bit different than utilities in the M&A context because, while banks are regulated, they are regulated not so much in terms of pricing of the product to the consumer, and they do not provide a monopoly last-mile service to the end user. It is easier from a regulatory and economic perspective to form new banks, to combine banks, and to consolidate the banking industry than would seem the case in the electric and gas utility businesses.
Mayo Shattuck, who is CEO of Constellation Energy, said recently at a Constellation shareholders meeting that he believes we will be down from a hundred major electric utilities in this country to 50 within a few years. He pointed out that Japan has only seven utilities for 120 or 130 million people.
A few days ago, an investment banker named George Bilicic at Lazard was quoted in the Wall Street Journal as saying, “I think this sector will be white-hot for the next two years. This industry is more fragmented than any other.”
Many people believe we are about to see a wave of utility consolidation in the United States, but there are also doubters who take issue with the conventional wisdom. With that background, let me ask Steve Reynolds: where do you see this going? Will we see a large number of utility mergers?
State PUCs as an Obstacle
MR. REYNOLDS: I can’t help but reflect when I hear Mayo Shattuck talking about consolidation that there was a sell side analyst 20 years ago who predicted that that there would only be 12 utilities left in the country by 1990. He has taken a lot of grief in the last 15 years because it did not happen.
The truth is there has already been a wave of consolidation, but it slowed after Enron collapsed. I think you will hear from Peter Rigby that one of the key issues is the financial health of potential merger candidates.
My utility is a product of a merger. In 1997, the electric company bought the gas company, and in the seven-plus years since then, the financial strength necessary to move forward from both a credit rating standpoint and balance sheet standpoint has been slow to be achieved. That is an issue that I think those who predict a large number of mergers need to take into account in their calculations. Some of those trying to fan the flame of merger mania today are the advisers who would work on any deals. It is important to keep such predictions in context. If you look at some of the mergers that are being talked about today, they have fairly unique circumstances that may not — I would underscore — may not be transferable.
It has been fascinating in our neck of the woods in the Pacific Northwest to watch the MidAmerican acquisition of PacifiCorp. It is not clear whether it is really an indication of a new wave of merger activity as much as a very strong signal from ScottishPower that it believes it made a mistake coming to the United States. The consequent acknowledgement of that in the dollar writedown the company took upon announcement of the sale indicates that it is having a very difficult time dealing with state regulatory economics.
If I were to offer any observation today, it is that regardless of whether the Public Utility Holding Company Act is repealed, deals will still need state approval. We have just seen a state reject the proposed acquisition of Portland General by a private equity group. We saw the same thing in Arizona with the KKR-UniSource deal. There are difficult state issues that are a barrier to the type of merger mania that some forecasters foresee. That does not mean mergers have no value. There are good arguments for the advantage of scale in the interest of ratepayers that often are not very well understood by more parochial state commissions, cities and others.
Effect on Credit Ratings
MR. GOLDEN: Let me move next to Peter Rigby. Standard & Poor’s has just issued a report that suggests that the rating consequences may make many utility combinations challenging.
MR. RIGBY: Our experience is that when utilities have merged, the cost savings that were touted as one of the reasons for merging never really materialized. They were harder to achieve than the companies expected. Bringing the companies together was much more difficult and took longer than expected. Merger proposals also face regulatory risk. Most regulators will want to grab some portion of the anticipated cost savings — if they ever materialize — for ratepayers because ratepayers, rather than the providers of capital, tend to be their primary interest. Right there is the reason why it is tough for mergers and acquisitions to lead to any sort of positive rating.
That said, if a very large entity acquires a very small entity, particularly if the smaller entity has a lower rating, it will probably not have much effect, if any, on the larger company’s rating, and it will pull up the rating of a lower-rated entity.
The types of mergers we are seeing today tend to involve companies that are roughly comparable in size. Exelon has about $40 billion dollars in assets; PSE&G has about $29 billion dollars in assets. In that case, we put Exelon, which was the higher rated entity, on “credit watch negative.” We put PSE&G on “watch developing” because we are unsure how the pieces will fall out in that merger.
With the Duke-Cinergy merger, we put both companies on “credit watch negative.” Duke is the bigger company, and it had the lower rating. We are not sure what will happen. We have not figured out yet exactly why this merger is happening and how things will unfold. Cinergy’s rating will probably end up closer to Duke’s.
With MidAmerican Energy and PacifiCorp, the PacifiCorp rating was largely a function of the consolidated rating of its ScottishPower parent entity, which was higher rated. We put MidAmerican Energy Holdings on “credit watch positive” mostly because we have a better understanding of how MidAmerican has handled acquisitions in the past, and that is a better way to describe what the company has done with acquisitions as opposed to merging. We don’t see PacifiCorp being merged into MidAmerican Energy Holdings.
To get back to our report or article, there are three or four main points.
First, utility mergers tend to jeopardize a company’s credit profile more often than not, partly because the industry is highly regulated and it is very fragmented. The way it is regulated tends to make what you might achieve in other industries more difficult to achieve in the utility industry. Second, as with many other mergers, the cost synergies may never materialize. Third, there is regulatory risk. The regulators may take some or all of the savings. They may also force divestiture of certain assets that the merged entities might not have counted on, which would then change the economics. Finally, it is unclear whether repeal of PUHCA will have a meaningful effect on utility credit profiles, because it already looks as though the states are stepping in to fill whatever void will be created. For example, Steve Reynolds just mentioned about what happened with Arizona.
MR. GOLDEN: Let me move to another issue that is tied to PUHCA repeal, and that is the possibility of other players coming into the industry. PUHCA requires that anyone who owns 10% or more of the voting stock of a public utility company must register with the Securities and Exchange Commission and submit to strict regulation on its ability to raise financing and do a host of other things. PUHCA has been an obstacle in particular to non-utility players coming into the industry because they must divest themselves of nonutility lines of business. Will PUHCA repeal bring a lot of fresh capital into the utility sector? Michael Hogan?
Influx of New Capital?
MR. HOGAN: Not many people realize this, but we have five million customers in North America. We are actually the largest retail energy provider in North America, and we have not had to think much about PUHCA.
Maybe that has more to do with who were are. We are a marketer. We also are an E&P company in gas, and we generate electricity in Texas. We are operating very effectively, very successfully, very profitably as a marketer in Ontario, Alberta, Texas, and increasingly in parts of the upper Midwest and the Northeast. We are in nine states; we are in the process of entering three more in either the gas or the electricity market or both, and we just don’t see PUHCA as an impediment.
There are some good reasons to repeal PUHCA. It chokes off investment in the transmission sector by trapping transmission assets inside outmoded and outdated local vertically-integrated utilities that either cannot or will not invest in transmission. PUHCA also inhibits competition by driving greater regional concentration in the generation sector. Finally, PUHCA also leads to regulatory duplication of effort. The SEC performs functions that the Federal Energy Regulatory Commission and the US Department of Justice are better placed to fulfill.
We do not think PUHCA repeal will have much of an impact in terms of utility consolidations, except perhaps at the margins.
The most interesting question is whether utility mergers are a good idea. How many of these deals are going to take two plus two and create three-and-a-half?
MR. RIGBY: People have argued to us that PUHCA repeal will bring lots of new capital to the industry. Perhaps that’s true that it will bring new capital, but this is an industry that has not had much difficulty attracting capital. Almost every week, some utility is issuing a bond, and none of these bonds issues has had a problem attracting investors. Look at how much money the merchant power sector was able to attract a few years ago, not that was not money well spent. There seems to be plenty of money, and the industry has had no trouble attracting it.
MR. HAUG: If two big utilities merge, CEOs and CFOs get a lot more money, the regulatory guys have a lot more staff, the accountings have a lot more staff, and all the people in the acquiring company are going to have an incentive to do the deal just from personal and career perspectives. The investment bankers will make huge fees. The process of going through the regulatory approvals will generate lots of fees for people.
I don’t want to sound cynical. The paper that Standard & Poor’s did is really good. It points out that you can have a lot of consolidation activity without any underlying substance. It is always hard to argue that having your local utility owned a long way away by people who aren’t your neighbors is a good thing, and I don’t think it will get any easier. However, there will be huge drivers to get such deals done because the M&A industry and the amount of private capital looking for a home. Merely moving money back and forth may not create synergy, but it creates lots of fees and lots of economic wealth.
MR. REYNOLDS: I don’t disagree. I think I tried to say the same thing a little bit more gently. There are differences among the deals that have been announced to date. Over time, there will be companies that will decide to sell certain assets that no longer fit into their revised business plans and who are driven to a merger after concluding that it will improve the balance sheet and credit position.
The fundamental problem with a merger for what I would call the classic regulated entity is regulatory accounting does not reward anyone from a financial standpoint, absent a lot of synergies, and such synergies are very difficult to find.
AUDIENCE MEMBER: We have heard this morning that there are three drivers for utility consolidation. Actually, one was in the newspaper about the Duke-Cinergy deal. It appears that Cinergy has so many coal-fired units that it needs access to the Duke nuclear units in order to meet its pollution control requirements. We heard David Haug’s suggestion that the market just throws up deals to do things. And then the suggestion was made that some CEOs just want to sit atop a larger company. Are there any other drivers for consolidation besides those three?
MR. REYNOLDS: Another possible driver is there are going to be huge capital requirements in certain areas of the country. I would use the Pacific Northwest as an example. One of the reasons that ScottishPower withdrew may be that several billion dollars of capital will have to be invested in additional generating capacity. ScottishPower must not have believed that it could get the return it requires as a public company. Meanwhile, Warren Buffet comes along, and he says, “I have $45 billion parked. I am happy to invest, I am going to be a long-time holder, and I believe that’s the type of return I can get.” When Buffet can buy at the price he has been offered, he probably has secured himself a reasonably good investment.
MR. MARTIN: What does Warren Buffett know that ScottishPower did not? How can PacifiCorp be a good investment for him when it was not for ScottishPower?
MR. REYNOLDS: When you buy a regulated entity more cheaply than the original buyer did, you do not have to worry as much about synergies and cost savings in order to get your return. If you can run a pretty good utility, then you can get a regulated return, which is what PacifiCorp is — strictly a regulated entity. Buffet will still have the challenge of regulation in six states and the risk that each state may require a pound of flesh, which is what has tended to happen to PacifiCorp over the years.
MR. RIGBY: One might argue that MidAmerican Energy Holdings and David Sokol are in a better position to deal with the quirks of US regulation than ScottishPower is, since ScottishPower is 6,000 miles away.
MR. REYNOLDS: I think you are pushing it, Peter. I don’t know that David Sokol in Omaha is any better able to deal with the Utah, Oregon and other state commissions. However, MidAmerican does not have the same “foreign ownership” taint, which in the West was an issue for ScottishPower.
MR. HOGAN: Just to add to that, as a North American subsidiary of another British utility company, British Gas, I think ScottishPower had some other issues. It is a small player in a rapidly consolidating European market, and the PacifiCorp thing just increasingly looked like it made no sense whatsoever. It was a drag on earnings; it was a drag on future capital commitments, and ScottishPower got huge kudos for dumping it in the European share market.
There are many instances of Europeans acquiring North American subsidiaries and finding — surprise, surprise — that they had to deal with unpredictable state commissions. Centrica has had good success here. Someone made the comment earlier that perhaps one driver for some deals is people want to merge their way out from under state commissions. Perhaps there is something to that.
Because we are rolling up customers, not wires and pipes, we can do so with relative ease. We have other issues about opening markets to real customer choice in, but rolling up customer bases is an easier proposition than what ScottishPower tried to do.
The idea of merging companies for the sake of size invites a backlash from state regulators who fight such mergers for fear that the merged entity will be beyond their control. Maybe the end game is the law of unintended consequences. It is that these entities will become either deliberately or as an unintended consequence unbundled to the point where the piece of the business that does lend itself to economies of scale and to the ability to grow and roll up customers and diversify and multiply services and products is the piece that will eventually be taken out from under state commission control.
MR. MARTIN: Let me suggest another possible driver for deals. The United States is a market in which certain types of projects or assets are rewarded with tax subsidies. Europeans coming into the US cannot compete effectively in this market without a tax base. ScottishPower needed a tax base to get a jump on the wind market.
MR. WENNER: Another type of acquisition or consolidation which may be made a lot easier by PUHCA repeal is for the transmission-only companies — the Trans-Elects of the world — that are constrained today by PUHCA in that they can only control a transmission system in one part of the country. With PUHCA repeal, they will be able to own transmission systems throughout the United States and, unlike utilities in the retail business, they would be subject to exclusive federal regulation by FERC for all of their properties. For that type of company, PUHCA repeal could be a very significant opportunity.
Lessons from Past Deals
MR. SEIPLE: Over the course of the past year, we conducted detailed interviews with executives at 12 companies that had previously gone through large-scale mergers and acquisitions in the power business. We interviewed them about what they thought they were going to achieve through the merger and then what actually happened after the merger. We were interested in finding out what lessons can be learned from previous rounds of M&A. I could talk for three hours about all the things we learned.
One interesting comment we heard over and over again from all the utilities interviewed was: “We thought our core competency was regulatory management skills. We did not realize that it was incredibly local and only related to our state PUC.”
The second thing that was interesting — and I think this applies to the Exelon merger in part — is that a number of utilities have cited a kind of diversification of regulatory risk as justification for mergers. Most people we interviewed said that post merger, they actually found that regulatory risk increased rather than decreased. All of a sudden, the state PUCs in one state were watching what PUCs were doing in every other state and always asking for better deals than what somebody else got in a different state. The merged company no longer had a home state in the sense it did earlier.
There were other interesting findings. In most transactions, costs actually increased rather than decreased after the merger. This was due in part to two factors — lack of experience in integration and underestimation of costs involved. If you look at the mergers three or four years after the transaction closed when the companies actually have their acts together, there are now substantial cost savings coming out of many of these companies. Statistical analyses we did indicated that there are economies of scale in the power business; they are not substantial, but on the order of 10% depending on the size of the companies that merged.
I sense that the industry as a whole has a much more intense focus on the issues of cost reductions, cost efficiency and things of that sort. Another thing we found in the analysis is there is a large unexplained difference in cost performance among individual utilities.
Contrary to some of what has been said today, our study suggested that if one can develop a competency in integration and move one’s own company to a point that it is far superior to others in terms of operational performance and then find someone who is willing to sell at the right price, then a merger or acquisition can create value. Few companies are in a position to do this, but it is possible.
There is a direct correlation in commodity businesses between the ownership concentration of the top four companies and return on capital employed. The greater the degree of concentration, the higher the return. This suggests to us that on the unregulated side of the business, consolidation could be healthy. One doesn’t have to look to do things on a national scale; increasing concentration in a regional market will do. The biggest challenge is regulatory oversight and whether the types of transactions that would actually create consolidation that was meaningful from a value perspective would be allowed by the regulators.
MR. HOGAN: If I could reinforce one thing Chris Seiple just said, one thing we have noticed, and it is a very mundane aspect of this, is the immobility for many regulated utilities of their regulatory expertise. Consider something as mundane as billing, collection and credit. They are one of the strongest competitive advantages one can have in building a customer base in multiple jurisdictions.
PSE&G left ERCOT and left a lot of blood on the table simply because — and PSE&G is a darned good New Jersey utility — but they left a lot of blood on the table because they could never get billing, collection and credit right under the Texas regulations. These are not easily transportable skills, and there are very few companies — and I would humbly maintain that we are probably one of them because of our experience with deregulation in Britain over the past 15 years — that have developed or will develop a platform that allows them to administer those very mundane aspects of operating in multiple regulatory environments.
MR. GOLDEN: Steve, do you have any thoughts on that, the issue of the economics of the day-to-day operational part of the business that Mike Hogan mentioned?
MR. REYNOLDS: Mike is absolutely right. Often, to get the synergy you need to overcome any premium that had to be paid for the business, you must integrate systems. Most of the systems in what I characterize as the vulcanized integrated utility systems that exist today are not scaleable. You cannot just merge two companies. You have to develop brand new systems rather than continue to use what one or the other incumbents has. That comes at a cost. Ultimately it may lead to efficiency because something new will be done that will probably improve things, but it may take five years to see any benefit.
We operate a fairly inefficient utility system in the United States. We have some giant utilities and then some really small companies, many of which are anachronisms that would have disappeared long ago but for local politics and local boards.
There should be a lot more consolidation. It can be expected. Virtually every large company today has a family tree of about 50 to 100 companies that at one time were consolidated into the parent entity that exists today. It is a natural thing for consolidation to occur. We have not had the economies of scale in the last 10 to 15 years to encourage it. I do not know if they will be there in the future, but I think as fuel costs in particular continue to skyrocket, everyone will be looking for ways to gain a cost advantage.
MR. MARTIN: I have a question for Peter Rigby. You listed at the start the utility mergers that are in the market at the moment, and it sounded like in every one of those cases, other than the MidAmerican-PacifiCorp transaction, the utilities that were merging are being downgraded or threatened with downgrades. Is there any circumstance where people will do better from a credit rating standpoint by merging?
MR. RIGBY: There are different ways to measure that. If you look at the marginal effect on the rated debt, certainly where a large utility buys a very much smaller one with a lower rating would be a case where the combined entity gains by merging. More than likely, what will happen is that the smaller one will see its debt get wrapped up into the larger entity because the difference in sizes is so big that the rating of the larger entity is unaffected. Such a merger helps the target utility.
Perhaps also if you have two utilities that are geographically contiguous, and they are about the same size, there are inefficiencies that can be squeezed out. That said, our experience is it is hard to realize such cost savings at least in the near term.
A friend of mine at McKinsey was sharing his thoughts about utility mergers. He thinks there are great inefficiencies to be wrung out of operations and maintenance, which is a big part of the cost to operate a utility. But the question to be asked is, “Why can’t a utility do that without going through a merger?” We have seen some of those kinds of efficiencies realized in generation when utilities sold off their power plants to the unregulated sector. The point is a merger may not be the best route to efficiency gains.