NextEra and Duke: A Third Wave of Mergers?
- Oct 8, 2020 5:06 pm GMT
To lay observers of the utility industry, recent events might seem puzzling. Faced with the headwinds of mounting unpaid utility bills and increasing debt from issuance of bonds, utilities will face a challenging business environment for the foreseeable future. This might be fertile ground for consolidation in the form of mergers and acquisitions. But last week’s news about NextEra’s acquisition offer for North Carolina-based Duke Energy turned out to be a non-starter.
A mega-cap deal between the two companies would have produced a behemoth. NextEra is the biggest utility by market capitalization and Duke is the country’s largest utility by number of customers. But M&As have had a checkered history in the utility industry. They rarely occur in isolation, are not dictated by balance sheets or income statement exigencies, and are almost always connected to broader events in the industry. There have been two significant cycles of M&As among utilities in the past. NextEra’s offer to Duke, while unsuccessful in its current version, may be the precursor to a third wave.
Regulation and Mergers
Unlike other industries, where mergers and acquisitions are mostly about gaining market share, the utility industry works on different levers. The driving force for the first two waves of mergers was regulation. The first one began in the early 1990s, after passage of the Energy Policy Act in 1992. Wary of an impending breakup of their vertically-integrated operations, utilities chased scale in their transmission and distribution units. According to research, most mergers during this period were horizontal mergers i.e., they occurred between utilities of equal size and in neighboring territories. The period also witnessed the influx of investors, money managers, and private funds into an otherwise conservative sector of the market. Even legendary investor Warren Buffett got in on the action in 1995 and launched a separate unit of Berkshire Hathaway dedicated to the utility sector. Their entry bolstered utilities’ cash position.
The second wave of mergers occurred around the turn of the century when actual deregulation of electricity markets occurred. Between 1998 and 2000, 45 corporate utility transactions were announced. Even as utilities divested most of their generation assets to recover “stranded costs”, they also snapped up other generating assets in distant geographies. For example, the New England Electric System (NEES) sold approximately 4,000 MW of generation and 5,000 MW of purchased power contracts to an unregulated affiliate of California’s Pacific Gas & Electric. Interestingly, most of these purchases were made using cash as opposed to all-stock transactions, which were the norm, during the first wave.
M&A activity has slowed considerably since then as utilities have focused on changing their generation mix in response to climate change. There were 70 investor-owned utilities in 2000. At the end of last year, there were 40. According to the Edison Electric Institute, an association of investor-owned utilities, 2019 was among the slowest year on record for M&A, with just three mergers completed last year.
A Third Wave of Mergers?
The industry is overdue another flurry of mergers for a third wave that reflects changes in the business environment for utilities. This time around, however, regulation may not be the driver. Instead, climate change will push utilities to merge with each other to create scalable operations. Recent developments in the energy market are indicators of this shift.
Oil and gas prices are a fraction of their peak from a couple of years ago and internal squabbling has marked OPEC’s recent negotiations. The seeming disarray in fossil fuel markets contrasts with the urgency to find solutions to the climate change problem. Conversations about carbon tax have gone mainstream and a slew of corporations and financial institutions have committed themselves to the idea of net-zero emissions by 2050.
Those last set of stakeholders might prove to be the genesis for more mergers in the utility industry. Consider the case of NextEra and Duke. Prominent holders of their stock include JP Morgan, the world’s biggest financier of fossil fuels, and Blackrock Inc. Both made formal announcements supporting climate change earlier this year.
A similar set of events have coalesced in Europe, where a third wave of mergers is already underway. Investment firms, pension funds, and oil companies have built up sizeable positions in renewable energy companies and utilities. In turn, they are providing the necessary ballast for these companies to expand or merge their operations.
The biggest single shareholder in Germany’s largest utility RWE is Blackrock, an investment firm whose chairman wrote about the climate threat changing finance earlier this year. Years of consolidation amongst power players has led to three utilities – RWE, E.ON, and Innogy – accounting for more than 70 percent of power generated in the country. The concentration of market power amongst the three companies has provided them with relative freedom to pursue their own collusive arrangements.
For example, RWE and E.ON split up the assets of Innogy, which is actually RWE’s green power subsidiary, in a complex arrangement last year. The deal expanded RWE’s operational footprint and turned it into Europe’s third-biggest renewable energy company from the continent’s worst polluter.
It is not inconceivable to imagine investors applying pressure on American utilities to accelerate their shift towards renewable energy. Several large utilities, including Duke, are in a similar situation as RWE. While it recently committed to spending $56 billion on renewable energy over the next five years, Duke is also saddled with legacy coal capacity. According to a 2019 report, the utility was the biggest polluter of carbon dioxide in the industry. A merger with NextEra, which has the world’s biggest renewable energy generation portfolio, will boost its renewable energy creds.
Despite public pressure, the third wave of M&As may not occur until after the effects of the pandemic subside. For one, regulation in the United States is still a stumbling block to large M&As. The dispersed jurisdictional authority is meant to encourage competition and prevent concentration of market power. But a merger like the one between NextEra and Duke, where both utilities operate in contiguous geographies and have years of experience dealing with regulators, should pass muster. Utilities also need to take a hard look at their balance sheets post-Covid. They have issued increasing amounts of debt during the pandemic and a big merger will further sap their finances and affect their investment rating, a prospect that may not sit well with regulators. In an August earnings call, James Robo, CEO of NextEra, told analysts that the company was planning to achieve its long-term growth objectives without the need to make any acquisitions until 2022.
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