The utility business environment is unique, complex and not for the faint of heart. Utility companies are sensitive to market pressures, regulatory constraints, and many other factors outside their control. The often repeated chorus about the changing business environment includes aging infrastructure, rising environmental compliance costs, flat or declining load, changes in customer expectations, competition from distributed energy resources and declining returns on equity approved by regulators. Some analysts suggest the electric power industry in the United States will need upward of US$1 trillion in capital investment over the next two decades to modernize aging infrastructure and to comply with new environmental regulatory requirements.
Electric Utility Rate Cases Increased in 2018
Utilities have had to pursue increasingly large rate increases through frequent rate cases to offset these industry disruptions. In fact, in 2018, nearly half of the major investor-owned utilities in the United States filed rate cases with state regulatory commissions. Of the 89 utilities that filed rate cases in 2018, 10 proposed to decrease rates, 1 negotiated a rate freeze until 2020 and 78 proposed rate increases. Frequent rate cases also aren’t so great for public relations.
Before my current role at T&D World, I previously led utility rate case initiatives and was once portrayed as the “Gassy Grinch” in a local newspaper cartoon after the natural gas company I worked for received approval for a 49% rate increase right before Christmas! That hurt my ego, but that large of rate increase hurt the ratepayers even more.
A Strategic Lever
A business environment where the costs to generate and deliver electricity are rising and revenues are flat or declining is not sustainable over the long run and has caused utilities to look at other strategic solutions. Mergers and acquisitions (M&A) are one strategic lever that utilities use to mitigate this death spiral. M&A have the potential to help control costs, increase revenues and mitigate risks by leveraging economies of scale. M&A are also often considered a win-win scenario for both shareholders and customers.
Recent mergers and acquisitions have significantly changed the utility landscape. In fact, the number of publicly traded electric companies have declined 57% since 1995. In 2000, there were 80 publicly traded electric utility holding companies in the United States, but this had shrunk to only 42 by the end of 2018. In the last five years, 24 deals were announced, with 18 being completed.
According to the Edison Electric Institute, three significant deals have recently closed (through February 2019). In early June 2018, after two years of effort, Westar Energy and Great Plains Energy completed a merger that formed a new utility holding company, Evergy, Inc. I lived through this transaction too, and it was a LONG two years. More to come on the length and complexity of regulatory proceedings later. Dominion Energy and SCANA closed on Jan. 1, 2019, and CenterPoint Energy and Vectren finalized their transaction on Feb. 1, 2019. On Jan. 23, 2019, Canadian utility Hydro One and Avista withdrew from their plan to combine after Washington state regulators rejected the deal due to concern about Ontario’s political influence over Hydro One.
While M&A can be a strategic lever, there are several reasons why it is often not pursued by power companies. First, as the industry continues to consolidate, there are decreasing opportunities for M&A activity (there were only six deals announced in 2016, three in 2017 and two in 2018). The sheer size of the investment can also limit mergers and acquisitions. And when opportunities do come up for the right-size deals, the competition is intense. This helps explain why valuations have also reached record levels. As I’ve already alluded to, the regulatory environment is also challenging: It is complex, has long approval timelines and creates uncertainty. It can also be difficult to demonstrate cost savings and synergies. Did I mention that the recent Evergy transaction took over two years? The backstory is that this transaction had actually been contemplated and tried in one form or another since the 1980s.
A New Lens
I recently read an analysis of utility M&A activity that suggested that industry consolidation has increased profitability but has also resulted in decreased returns on shareholder investments in assets, equity, and capital. Those results seem to be as clear as mud and may not necessarily support the case of new M&A activity in the industry.
Financial metrics are not the sole reason utility M&A should be pursued. The changing utility business environment should also compel us look at M&A through a different lens. While cost savings to customers will continue to be a powerful driver for M&A activity and a litmus test that regulators use to gauge the common standard of “public interest,” other attributes should also be considered by both power companies and regulators. Transactions that result in new revenue streams, enhanced competitiveness, innovation, increased reliability, and compliance with environmental mandates are also valuable to both shareholders and customers, which will continue to make utilities financially attractive for years to come.