European View of the US Market

European View of the US Market

August 01, 2004

Another topic at the Chadbourne conference this year was what opportunities Europeans see in the US market, what they are telling their managements about the uncertain US regulatory climate, and how the collapsing US dollar figures into their calculations.  The speakers are Merrick Kerr, chief financial officer of PPM Energy, Gordon Currie, senior vice president and general counsel of Centrica North America, Vim Verbraeken, head of project finance lending for Belgian lender KBC Bank, and Alfredo Cahuas, chief financial officer of USA Gamesa Energia.  The moderator is Keith Martin with Chadbourne in Washington.

     MR. MARTIN:  Let me start with the collapsing US dollar.  I think it has come as a surprise to many people in this country that with the dollar having lost 40% of its value against the Euro since early 2002 and 25% against the British pound, European companies have not been rushing into the US to buy up cheap assets.  Merrick Kerr, why not? 

     MR. KERR:  When you look across the US at the assets that have been available -- some pipelines, generation assets some of which have long-term contracts against them -- although they are cheap in dollar value compared to the Euro, you are competing against private equity funds and others here with a lower cost of capital. 

     The other issue is I think companies make a mistake to behave opportunistically.  You really need to have a reason beyond mere opportunity to be in a country and a strategy for pursuing it. 

     When we bought PacifiCorp, we thought the dollar was already weak against the UK pound.  Since then, we have had a $400 million gain purely on currency fluctuation.  We hedged against the risk, and the hedges were so deep in the money by this year that we were able to free up that amount in cash.  The point is it shows the significant risk that companies take on currency.  Who can be sure the dollar will remain at the current exchange rate?

     MR. MARTIN:  You suggested private equity funds have a cheaper cost of capital.  Therefore they are better able to compete for assets that have been put out for bid.  Why is that?  Why are Europeans saddled with more expensive money? 

     MR. KERR:   To be honest, it is not necessarily the cost of capital but the lament of all bidders who offer too low a price.  When we have bid on contracted assets and pipelines, the number that we feel comfortable offering is significantly below what others are willing to pay for the same assets. 

     MR. MARTIN:  I think almost everyone in the room would say the same thing: how could that other guy justify paying so much?  Gordon Currie, why aren't Europeans here in greater numbers?  

     MR. CURRIE:   I very much agree with what Merrick Kerr said.  I cannot remember a single project of the many projects at which we have looked in the last two or three years where the relative level of the dollar to the British pound, which is our currency conversion as well, has been a factor in the early stages in whether we would bid.  We think very much like Merrick said.  You have to justify the acquisition on the strategic merits and on a value basis in the local currency, and the treasury guys do their thing to get the earnings back to the UK.

     MR. MARTIN:  Wim Verbraeken, you and I spoke about this last night at dinner.  You have another theory for why the Europeans are not here in larger numbers.

     MR. VERBRAEKEN:  It is as Merrick Kerr said.  Those who rushed into a certain country because of particular circumstances -- whether it is a crisis where assets are cheap or a currency advantage -- have later regretted the decision.  I get a sense from talking to European sponsors that people are nervous about political risk, and I am not only referring to California but to the lack of a clear regulatory framework and how the entire crisis in the power industry will ultimately play out.  As an outsider, you are not part of the political game that is being played.  Some sponsors doubt whether they can compete at a political level with the incumbents.

Regulatory Morass?

     MR. MARTIN:  Marco Arcelli from ENEL, who could not be here, said something very interesting on a call last week to prepare for this conference.  He is from Italy.  He said, "I thought Italy was Byzantine enough, but here you have federal rules, state rules, county rules.  I wonder whether there is a finish line."  It was interesting to hear an Italian company describe the US as chaotic. 

      Let me focus on regulatory risk.  Alfredo Cahuas, you are new to the US market.  What do you tell your management about the regulatory risk here?  Is it greater than what one would find in Spain, for example, or in Latin America?

     MR. CAHAUS:  I think the regulatory risk is more challenging here.  You have a patchwork of federal and state laws that you need to follow.  Just look at transmission and the patchwork of rules governing it.  Our senior management in Spain finds it frustrating not to be able to get a single answer to the questions it asks.  The answer is always, "It depends on the state where the project is located." The rules here are more complex and difficult to understand, and this ultimately makes it more expensive to do business here. 

      MR. MARTIN:  Gordon Currie, how great an issue is regulatory risk in this country?

     MR. CURRIE:  It is absolutely at the core of virtually everything we talk about when we try to explain to our UK parent what we are trying to do in this market.  One thing European companies learn quickly is that it is not really at the federal level that so many of these issues play out.  The old adage is that all politics are local.  We have all had to endure some painful experiences to learn that what happens at the state level -- or even at the municipal level -- can be more profound than what happens nationally.  We still pay attention to what the Federal Energy Regulatory Commission is doing, but we gave up long ago trying to explain what the national energy plan moving through Congress was all about.  The board said don't bother us about it until it is done.  It is at the state level that we are the most focused.              

     MR. MARTIN:  Are there any parts of US that you simply ruled out as presenting too great a regulatory risk?

      MR. CURRIE:  It is not so much regulatory risk and the regulatory environment.  We are not spending a lot of time in the southeast or northwest, given what we are trying to do as a retail energy provider, because these regions remain largely closed to competition.  We are spending much more time in places like Texas and the northeastern US where, although there is certainty, there is also opportunity.  We look at the US on a state-by-state level and, indeed, in Canada we do the same thing.  In Canada, of course, we do it in two official languages so it gets even more complicated.

     MR. MARTIN:  Merrick Kerr, are there any parts of the US that you have ruled out because of regulatory risk? 

     MR. KERR:   Not really.  I don't think regulatory risk rules out an area altogether, but it does limit the potential for growth.  Great uncertainty and regulatory confusion in an area make it difficult for us to persuade the Scottish Power executive board that there is much opportunity for growth.  PPM is concentrating for now on the wind and gas storage businesses.  I will say one thing in defense of the US.  Trying to build a wind farm in the UK is more difficult than build one in the US, even in California.  It got to the point where our group CEO went public in the press with his complaints.  He said basically to the UK government, if you don't find a way to allow these plants to be built more quickly, we will take the money we had planned to invest in wind farms in the UK and put it into the US.  The point is the US is not alone in having regulatory issues.

Cheap Dollar

      MR. MARTIN:  Chadbourne asked the audience at a conference in the early 1990's which country has the greatest regulatory risk, thinking it was China or India, and a majority of the audience responded New York state.  Come back to the collapsing US dollar.  European companies do not find the cheap dollar enough reason by itself to invest in the US market.  Are there consequences from the cheap dollar for companies like yours that are already here operating? 

     MR. KERR:  Scottish Power learned at home before coming to the US how deregulated markets work.  It entered the US market by acquiring PacifiCorp.  The original business plan was to get a foothold in the northwest in advance of deregulation in that market and use what we learned about competing in deregulated markets in the UK.  Then, of course, the market changed because of California.  The most important point for anyone entering the US market is you have to remain flexible. 

     Returning to the dollar collapse, it is of greater concern to companies that are already heavily invested in the US than to new entrants.  We have a large balance sheet in the US.  We have debt in US dollars that we are working hard to balance against our US assets.  But as I said before, we are hedged.  We have a tax base here for using production tax credits from our wind business.  The entry through a utility gave us some political influence at a local level and an A- credit rating to support what we wanted to do on the unregulated side.  This proved a very good way to enter the US market.  Whether others entering the market should use the same approach depends on what they want to do on the unregulated side. 

     MR. MARTIN:  Alfredo Cahaus, Gamesa is a new entrant to this market.   Does the weak dollar play into your calculations?

     MR. CAHAUS:   Our take is slightly different than my co-panelists' because, at the end of the day, we are a capital goods company.  We manufacture and sell turbines.  What does it mean to have a  collapsing US dollar?  It means that our equipment is 20, 25, almost 30% more expensive, and it is hurting us.  It actually hurts the entire wind sector when you consider that about 70 to 80% of the total capital cost of a wind farm is in the wind turbines and when you consider further that the majority of the manufacturing capacity is European-based.  The weak dollar is a burden on the entire sector. 

     That said, I agree with what was said earlier that, at the end of the day, you look at whether there is any broader strategic reason to be in a market and then get the treasury guys to work on how to hedge the currency risk.

     MR. MARTIN:  One of the greatest areas of activity for European companies here is renewables.  Witness that two of the European companies on this panel -- Scottish Power and Gamesa -- -- and a third that was to have been represented -- ENEL -- plus Airtricity on the preceding panel are focused on renewables.  The US encourages renewables through tax subsidies.  It is surprising to see so much effort in the one sector where one needs a US tax base to play effectively in the US market.  Why have the Europeans focused on the one sector where they are at a competitive disadvantage? 

     MR. CAHAUS:  I think one word -- size.  We believe that renewable energy will play an important part in the overall energy mix in the US.  I doubt it will be as important as in Europe, but picking up something that Ciaran O'Brien from Airtricity said earlier today, when you look at the size of the pie, it is huge.  Sure, Europe is a large market, but the penetration for renewables in Europe is already between 15 and 20%.  In the US, it is about 2% taking into account all technologies.  If we were to reach 5% market penetration in the US, we would be looking at total investments of $18 billion.  So, from that perspective, being in the US is absolutely critical. 

     Another point is I think all the elements are in place in the US.  Yes, there are uncertainties.  There are challenges with production tax credits, and they make it very tough for foreign participants like us to participate effectively with some of the local players but, at the end of the day, there is demand for renewable electricity.  We are seeing more states moving to put renewable portfolio standards in place.  Some states have consumer choice.  There will be continued growth in this sector.    

Too Much Politics?

     MR. MARTIN:  Let me switch topics slightly.  Gordon Currie, you interviewed Chadbourne at one point as a potential counsel to Centrica, and one question you asked that was very interesting was about whether Chadbourne had any political muscle or ability to sway regulators and legislators in aid of projects.  Do you think that is a more important skill when doing business in the US than, say, Canada or Britain? 

     MR. CURRIE:  A public company in the UK or European Community cannot make political contributions unless it gets shareholder approval, and our company has adopted a policy of no political contributions.  That does not mean we do not hire lobbyists.  We just can't make political contributions.  In Canada, political contributions are capped at $1,500 per year per political party at the federal level and at correspondingly small amounts in the provinces. So you have a British company that has a regulatory constraint against engaging in the political contributions game at home and, in Canada, the dollar limits are so small as not to be meaningful. 

     There are complex rules in the US.  You have first to learn them.  When you are Centrica and a big player in the UK market -- we go back more than a hundred years as British Gas -- it is no trouble to get an audience.  When I walk into this room, not everyone knows what Centrica is.  It becomes more important for us to find out what the rules of the game are for making oneself heard whether they be political, regulatory or commercial. 

     I agree with something Merrick Kerr said.  Being on the ground as a participant -- particularly as an incumbent -- is very important.  Having employees who are on the street talking to customers, talking to regulators, talking to all of the different stakeholders, including the people in this room, gives a company a different level of information.  That information is by order of magnitude better than just relying on internal analyses and talking to advisers and lobbyists. 

     MR. MARTIN:  Merrick Kerr, let me ask you the same question.  We think of ourselves in the United States as having a free market system.  The government lets businesses do business largely unfettered by regulation.  Is the US in fact such a political place that companies cannot function without lobbyists? 

     MR. KERR:  One of the differences between our home market in the UK and the US is that, in the UK, you have five or six large integrated companies with generation and with customers, a couple transmission companies, and a handful of distribution businesses that are regulated, and everybody has the same access.   There are some smaller wind developers in the UK, but you are basically talking about five or six very large companies with similar goals competing against one another under a common set of rules. 

      You come then to the US where you have municipal corporations, IPPs, fully-integrated IOUs, many wind developers of all shapes and sizes, and QFs -- all competing in the same space under federal rules, under state rules, and under local rules.  This is a very different environment from Europe, and if you do not have the right relationships with the regulators at each level, you are not going to win.  There is no doubt that the one thing you need to succeed is to be able to play the regulator game.  

Why the US?

     MR. MARTIN:  Let me ask the two biggest companies, starting with Gordon Currie -- does the push you are making in the  US market suggest there is not much opportunity elsewhere and, if there is opportunity elsewhere, where does the US rank in Centrica's view of good markets in which to pursue investments?   

     MR. CURRIE:   The reason we are here is the US is huge market.  Yes, it is complex and, yes, it is difficult and, yes, the currency exposure is challenging.  Welcome to being a multinational.  That is just a fact of life, and you have to get on with trying to pursue the best opportunities.  We think there are tremendous opportunities in North America for what we are trying to do.  Therefore, the answer to your first question is no, we are not here because there is an absence of opportunity elsewhere.

     Where does North America, and I put it that way because we are heavily invested both in Canada and the United States, where does that rank in Centrica's plans?  I'd have to say very, very high.  That is a matter of public record and, indeed, our stock price is influenced significantly by what the analysts think of how we are doing in North America, despite the fact that on an overall consolidated basis, North America is still a relatively small portion of the overall mix compared to the business back in the UK. 

     MR. MARTIN:  Merrick Kerr, where does the US rank in Scottish Power's hierarchy of opportunity? 

     MR. KERR:  We have a different take on the US market than Centrica does.  The level of our investment here is a bigger problem for Scottish Power.  As much as 60% of our business is in the US.  We grew through acquisitions in the UK, but then did a very broad search of basically continental Europe, Australia and the US and made the strategic decision that the US presented the best opportunity for further growth.  We had a couple near misses before acquiring PacifiCorp.

     The opportunities to grow PacifiCorp were not what we expected so we created PPM Energy on the unregulated side just three years ago with 12 people.  It has grown today to 220 people and a lot of assets, and it represents a sizable investment for Scottish Power. 

     MR. MARTIN:  What is interesting is the incumbents in the US market have been lamenting for the last few years the lack of opportunities here.  Here are two European companies that see significant room for growth.  I know that PPM Energy has identified wind farms and gas storage facilities as its two areas of focus.  What does Centrica see as its principal opportunity? 

     MR. CURRIE:   We are a retail energy provider but, consistent with the strategy in the UK and elsewhere, we look to hedge 25, 30, as much as 50% of our downstream obligations in the form of upstream physical assets.  So, that means buying power generating facilities, investing in gas properties upstream and the like.  We are not interested in being in the middle.  Someone described it to me as the dumbbell strategy.  We like to think of it a little differently.  Both ends of the spectrum but not the role in the middle.  

     MR. MARTIN:  Alfredo Cauhuas, where does the US rank in Gamesa's hierarchy of opportunity?

     MR. CAHAUS:   It is a priority market, and that is something that our CEO has expressed time and time again. To take a step back, why are we here?  There are opportunities elsewhere.  In fact, we are very active in Europe and in the rest of the world.  The reason we are here is it is a kind of natural progression for our company as we expand our international footprint.  Given the size of the US market, clearly we need to be here.

Lessons Learned 

     MR. MARTIN:  There is a feature in a magazine in Washington called The Washingtonian in which a writer, an intellectual, or a political figure is interviewed each month, and the last question is always, "What have you learned about life?"  Gordon Currie, let me start with you.  If you were advising a company entering the US market for the first time, what important lessons would you convey based on your experience to date?

     MR. CURRIE:   All politics are local.  You have to look at the US market as a series of many small markets that are often very different.  Doing business in the southwest is different than doing it in the northeast.  Pay attention to what is happening in a clearly defined region.  Understand that region.  Don't underestimate the power of incumbency.  Be on the ground.  That is a challenge because you do not want to invest until you think it is a place you can make money but, equally, you cannot truly understand a market -- particularly the regulatory component -- without being there in person.   

     MR. MARTIN:  Another point you made to me before this conference is it is hard to get scale in this country given the fragmented market; just focus on one or two. 

     MR. CURRIE:   Absolutely.  In our case, we are in four regions in North America -- two in the states and two in Canada -- and, for the foreseeable future, we will try to mine those regions and avoid spreading ourselves too thin.  Just to give one example of the challenge of trying to operate too broadly, the rules for billing of retail customers change not only between states but sometimes within states and different utility service territories.  That means you cannot have a common platform that we just push a button and the computer spews out the bills.  You are forced to customize.  You need a call center where the employees understand the local rules.  There are some economies of scale and there certainly is expertise that you can apply across the board, but the local theme is, to my mind, all important and it manifests itself in many different ways.

     MR. MARTIN:  And the call center is in India? [Laughter.]

     MR. CURRIE:   No, the call center is in Texas, thank you very much.  

     MR. MARTIN:   Merrick Kerr, what would you advise a new entrant to the US market given your experience here? 

     MR. KERR:  I agree with everything Gordon Currie said, but I would add spend time understanding the fundamentals of the market.  Understand what makes the market work, what gets rewarded and then try to find the skill you have that will give you an advantage.  If you come to the US without identifying an advantage, you will be eaten alive by the very large and very big players who are already here.  

     From the Scottish Power perspective, we could see right away that combined-cycle gas-fired power plants were in oversupply.  We did not have to be geniuses to see that.  What other things can we do?  Wind was an obvious answer.  The point is to identify a fundamental market that offers a chance at a reasonable payout.  We had a bit of an advantage given our experience with wind at home.  Similarly, the gas storage business is one that offers an opportunity to trade around the gas supply.  That was something else in which we had experience at home.  The ability to trade gave us a competitive advantage.   When such assets came up for sale, I was able to pay a little more for them than competing bidders because I knew I would be able to get the upside of optimizing and trading in those assets that others would be unable to achieve. 

     Figure out which parts of the business are going to be well rewarded and then if you have or can create a bit of an advantage.  Go for it if you can.  

     MR. MARTIN:  Scottish Power established a beachhead in the US by acquiring a regulated utility.  Is this a good place for others to start? 

     MR. KERR:   That's difficult to say.  Our original business plan did not work.  We bought the utility in anticipation of having to compete in a newly-deregulated market.  Where our strategy is now is to be very good at the regulation game.   PacifiCorp has turned out to be a good investment because of growth in the local market, particularly in Utah where we are building two CCGTs, and we will get nice regulated returns on them.  At the same time, the infrastructure for the distribution and transmission business also needs significant investment.  Was that the expectation when we came over?  No.  But things turned out well. 

     MR. MARTIN:   Alfredo Cahuas, what would you tell someone new to this market -- perhaps not to move to Minnesota during the winter? 

     MR. CAHAUS:  I agree with what has already been said about understanding the market fundamentals.  One thing I would add from a continental European perspective is do not underestimate the cultural differences.  Businesses are run differently here.  

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     Returning to the broader theme of this panel, I doubt we will see as wave of utility takeovers by Europeans in the United States.  Think back to 1999 and 2000 the last time people thought there would be a wave of M&A activity coming from European buyers and it did not happen.  It did not happen for two reasons.  One reason is cultural differences had a big impact.  They came out during due diligence.  The other reason is that the European utilities had already invested heavily in Latin America, and they were still recovering from the lessons they learned there.  We heard about the Spanish utilities paying big premiums in Argentina, Brazil and elsewhere.   So when the time came to look at the US, they were not ready.  Their balance sheets were no longer as strong.