Increased interest from non-commercials could turn out to be a double-edged sword.

A review of merger and acquisition activity during 2004 in the global gas and electricity sector, published by PricewaterhouseCoopers in February, confirms a sizeable shift in business development from globalisation to regionalisation strategies. Whilst not surprising in itself, as US utilities continue to divest out of international assets and become more entrenched domestically and an expanded EU provides scope for a more integrated regional EU market, what is a surprise is the apparent resurgence in health of the North American gas and electricity sectors. According to the survey the deal values in North America exceeded those of Europe – $46.5bn versus $32.8bn, although this can largely be qualified by Exelon Corporation’s $26.1bn purchase of PSEG accounting for almost half of the total deal value in the region while the umber of individual deals in Europe were 40 % higher than those in North America.

The US continues to be the poor relation to Europe in the gas and electricity sector. From a position of apparent strength in the late 1990s, as its utilities acquired swathes of businesses across Europe and Asia-Pacific, the double-whammy of the California crisis and the subsequent Enron debacle stripped market bare of confidence, crucified credit ratings and forced US utilities to divest international assets in order to protect domestic ratings. At the time a number of US market observers were adamant that this was a temporary situation and that US utilities would re-invest in international assets. But the US utility industry, like US politics, has become increasingly isolationist since the turn of the century and there is little prospect of US utilities again having a global presence in the gas and electricity sector. In the period since retrenchment the European entry barriers have been raised and it is no longer a question of US utilities re-entering Europe but whether European utilities will target US assets.

In defence of their domestic market US utilities have, according to the review, been looking to create a small group of ‘super-regional’ utilities in much the same way that Europe spawned a group of so-called ‘national champion’ utilities. These ‘super regions’ already exist on paper – the Federal Energy Regulatory Commission has a blueprint for a series of Regional Transmission Organisations and it would seemingly make sense for utilities to use these regional boundaries. As this group of super-regional utilities are formed, subject to regulatory approval, the US market could theoretically evolve into a two-tier market, which in turn presents cash-rich European and other non-US utilities with an opportunity to establish a presence in the US through selective joint ventures, although the US utility market would need to move further toward full deregulation before the potential rewards of investing in the US outweighed the risks. Most of this risk relates to the continuing uncertainty with respect to reform of the Public Utility Holding Company Act. While the US market is undeniably more buoyant than in recent years it still has significant progress to make before it returns to its pre-California level of prosperity, if indeed it ever does.

The same cannot be said of the European market, which continues to go from strength to strength, with bid activity among European entities increasing 24 % year on year according to the review. In tandem with the US market, European investment has been more inward looking over the past twelve months, but this has been through further consolidation and integration to achieve economy of scale as opposed to rebuilding domestic business following a programme of international divestment.

This summer will see a new integrated Iberian market (Mibel) finally emerge after a series of delays, preceded by an integrated British market for both trading and transmission as Scotland joins the England and Wales NETA market to form BETTA (British Electricity Trading and Transmission Arrangements) from 1 April. Meanwhile the governments of France, Belgium and the Netherlands agreed in March to work closer together to foster competition in their respective markets, and called on Germany and Luxembourg to join. Belgian grid operator is currently setting up its power exchange, Belpex, with links to the French (Powernext) and Dutch (APX) exchanges, with the possibility of a unified exchange evolving and hence the invitation to Germany and a link into the liquid EEX platform in Leipzig. While it is too early for talk of an actual ‘single’ Benelux gas and power market the forces of regionalisation and the economic benefits of scale suggest a Benelux region is not too far away, though it is highly doubtful that Germany would want to formally join such a regional grouping.

With US utilities completing international exit strategies, and European utilities focusing on Europe’s regional markets, deal activity in Asia-Pacific was dominated by ‘local’ companies with a degree of regionalisation evident but given that most of the countries in the region are still on the deregulation learning curve and with most of the utility assts still in government control the deal activity was limited to Australia, New Zealand, Singapore and Hong Kong-based companies. Indeed while the market structure exists for ‘super regions’ in Europe and North America the prospects for similar regionalisation strategies in Asia-Pacific are less promising, at least in the short to medium term, although there would be considerable value in a ‘single’ Southeast Asia regional market comprising Singapore, Indonesia, Thailand, Malaysia, Vietnam, Laos and Cambodia.

One of the ready conclusions of deal analysis is that it provides a reasonable assessment of market health, the argument being – the more money invested the better the market prospects as investors seek a return on investment. Equally, a high level of deal activity could indicate a market has bottomed out with cheap assets to be acquired. But it is not the quantification of deal activity that is important in assessing the health of the market but the quality of deal activity – ie are generators buying generating plant or supply businesses, are supply businesses buying distributors, how active are the non-commercials such as banks and funds in the deal process and is there reciprocal investment in and between the gas and electricity sectors? Two notable developments in deal activity last year, according to the survey, were the increased participation of non-commercials and a growing interest in gas assets.

Increased interest from non-commercials could turn out to be a double-edged sword. While a developing market seeks the injection of non-commercial capital as an endorsement of the perceived return on investment the increasing participation of these companies can have a detrimental impact on market development if there is not an equitable balance between commercial and non-commercial participation, as non-commercials are naturally shorter-term speculatively-geared participants.

By coincidence the publication of the survey of deal activity was in the same week that the European Commission proposed an investigation into the apparent stalling of EU gas and electricity competition. But all the Commission has to do is look at the increasing consolidation of vertically integrated companies as illustrated by the survey to identify the problem. The M&A market may well be in rude health but the internal EU energy market definitely is not.