A New M&A Strategy for Utilities
Utilities seeking to expand must be able to negotiate regulatory complexity while planning and executing deals effectively.
In April, Texas regulators rejected a bid by Florida utility giant NextEra Energy to acquire Dallas-based Oncor Electric, whose parent company was in bankruptcy. The regulators expressed concern that Oncor’s new board would be controlled by an out-of-state entity, which would impair local decision making. In May, Kansas regulators turned down the proposed sale of electric utility Westar Energy to Missouri-based electric utility Great Plains Energy, saying they were concerned about the financial leverage of the combined entity and its potential disadvantages for customers.
The deals are still pending. But these events show that mergers and acquisitions, which have been common in the utilities industry, could face heavier scrutiny going forward. That means utilities seeking to gain a competitive edge through M&A will have to convince regulators that the transactions will produce meaningful efficiencies and synergies. They must also show how their plans will translate into explicit benefits for ratepayers and improvements to transmission and distribution networks.
During the past two decades, the utilities sector has consolidated broadly. Since 1996, the number of U.S. investor-owned electric and gas utilities has decreased by around 60 percent, and the median market cap in the industry has risen to US$7 billion from $1 billion (see Exhibit 1).
Consolidation has been driven by several factors. Some utilities have been seeking to diversify regulatory risk by having operations in multiple states. Others have sought complementary assets, such as gas pipelines, or expanded into new service functions, such as gas distribution or electric generation. Regardless of the motivating factor, the overall outcome is clear. The utilities industry is top heavy; it has a majority of large companies and a shrinking minority of smaller companies.
As the opportunities for M&A narrow, the need for M&A as a vehicle for growth persists. Utilities face some significant challenges unique to their industry. Revenue gains from traditional areas such as power generation and distribution have stalled for most utilities. As services have accounted for a greater share of economic activity, demand for electricity in the economy has flattened. In some areas, demand is even declining, because population and business expansion is more than offset by energy efficiency and conservation efforts. In its annual financial review, the Edison Electric Institute reported that the number of gigawatt-hours available for distribution in 2016 was 2 percent lower than the 2008 figure.
With few organic growth options available, larger utilities — whether they are based in the U.S. or Canada — seeking growth have no choice but to try swallowing up smaller companies outside their home regions. Many traditional electricity providers are particularly interested in natural gas utilities. Thanks to the fracking revolution, natural gas has emerged as a plentiful, relatively low-priced feedstock that produces fewer emissions than coal or oil.
But as noted above, utilities seeking mergers don’t have a free hand, as companies in other industries might. State regulatory commissions as well as company shareholders weigh in on the merit of any transactions, which means that different stakeholder needs must be considered. In today’s utility sector, a fruitful M&A strategy — one that can provide a lucrative return on investment — contains three essential elements: the ability to navigate the regulatory approval process; a well-crafted initial integration plan that identifies specific gains and synergies; and a transition program designed to capture the projected value as soon as the acquisition is approved and finalized (see Exhibit 2).
Utilities-sector M&A cannot be approached as a one-size-fits-all effort. Utilities are regulated at the state level. And each state commission has different biases as to what it wants to see in an acquisition and what gains the deal has to deliver to the state’s constituents. For that reason, utilities need to approach a deal with sufficient up-front knowledge about what regulators are seeking. And they must be able to craft the application in ways that satisfy the commission’s goals or that can provide provisions regulators would welcome while ensuring shareholder returns.
Utilities are increasingly focused on making promises in areas such as maintaining current employment levels (or sometimes even increasing them), protecting local management, providing rate benefits to customers, and making ongoing investments in infrastructure. To gauge how regulators will receive an application, acquiring utilities should assess whether it demonstrates tangible benefits for customers and improves local economic conditions — or at least offers trade-offs that are advantageous to the community.
For instance, in 2016, when North Carolina–based electric and gas utility Duke Energy purchased a smaller North Carolina–based utility, Piedmont Natural Gas, Duke’s strategic rationale was to broaden its local revenue stream by enhancing Duke’s gas portfolio and expanding into neighboring states. To satisfy regulatory concerns in North Carolina and South Carolina, Duke made a series of commitments to provide assistance to low-income customers, make charitable and community support contributions — which are typically well received by regulators — and share any future merger savings with customers.
Given the scrutiny many mergers face, these were relatively easy demands to meet. It is more common to see regulators set out a broad set of conditions that can include separation of regulated and unregulated assets, service commitments, implementation of certain performance and efficiency standards, technology investments, promises not to raise rates, and restrictions on dividends to shareholders. Exelon’s mergers with Constellation (2012) and Pepco (2016) and Macquarie’s acquisitions of Duquesne Light (2007) and Puget Sound Energy (2009) each had to make clear commitments to pass regulatory hurdles.
Navigating the approval process is a difficult balancing act. Utilities have to be careful not to erode the economics of the deal by overpromising benefits while offering enough to satisfy state regulators.
The length of time between the announcement of a utility M&A and the closure of the deal has declined sharply in the past 20 years — from about two years in the mid-1990s to less than a year now. That short window is too precious to waste. Utilities should use that time to plan the integration, setting up operational and strategic initiatives that are ready to be executed and that can capture value from the day the merger is consummated. To do this, utilities should take a series of steps: