Eat or Be Eaten?

Issue 6 and Volume 109.

Perhaps we should have seen the writing on the wall. Earlier this year, the CEOs of two major utilities made speeches supporting the use of a carbon tax on fossil fuels to reduce greenhouse gas emissions in the United States. Those two utilities – Duke Energy and Cinergy – are now merging to create an industry behemoth with projected annual sales of $27 billion.

Most industry analysts have characterized the planned Duke/Cinergy merger as the first salvo in what could become a rapid-fire string of mergers and acquisitions. “Duke’s acquisition of Cinergy will likely speed the industry consolidation at the utility level and among merchant energy companies and their major suppliers, where you could see consolidation of as much as 50 percent of the players,” said Gary Hunt, president of Global Energy Advisors.

Have we reached that proverbial “tipping point,” where consolidation is essentially a foregone conclusion, where company boards huddle behind closed doors to debate whether they should eat or be eaten? Maybe, but I’m not convinced.

Consolidation certainly offers many benefits in today’s power industry, ranging from geographical diversification and fuel diversification to reduced overhead and shared resources. The industry’s path to consolidation, however, will not be a double-time march. It will be a lurching, zigzag stumble – the road littered with potholes too numerous to avoid.

AEP is still spending millions of dollars to argue the viability of its merger with Central and South West Corp. in 2000. An administrative law judge ruled in mid-May that the Security and Exchange Commission should not have approved the merger, noting that AEP and CSW are “clearly noncontiguous,” thereby violating the protective stipulations set forth in the Public Utility Holding Company Act (PUHCA) of 1935.

Exelon is facing its own complications in its planned acquisition of New Jersey-based PSEG. Although the geographical nature of this acquisition is less of an issue because of Exelon’s presence in neighboring Pennsylvania, various citizen groups are urging regulators to reject the merger because of market power concerns. In a proactive attempt in early May to expedite approval of the merger, Exelon and PSEG supplemented their initial February 4 merger filing with the Federal Energy Regulatory Commission with this offer: “Provided that FERC approves the merger without a hearing, the companies will divest additional capacity to address some of the concerns raised.” An astute, proactive strategic gambit, but also a tacit acknowledgement that the approval process could turn into something much less than expedited.

The experiences of other infrastructure-heavy industries – such as coal mining, railroads, integrated oil and gas – offer conflicting views of the value added through consolidation. Each of these industries has undergone substantial consolidation. In the coal industry, for example, the top 15 coal producing companies currently produce more than 70 percent of the coal mined in the United States, up from about 40 percent 20 years ago. In the power sector, the top 15 utilities account for around only 11 percent of total utility generation, and much less if all electricity generators are included, private, public and otherwise.

From a stockholder perspective, consolidation in these sectors has primarily been a plus, although it took many years in some cases to realize the value. From a customer perspective, however, the value proposition is less evident. Power plant fuel buyers, for example, are hamstrung in certain locales because of access to a single rail carrier for coal delivery or a single pipeline for gas delivery.

A big reason why the power industry has remained relatively disaggregated is because the product – electricity – touches consumers on such an immediate, intimate level. Consumers are much more likely to lodge a complaint against their power company than with an oil company, even though a 10 percent price increase for gasoline has a much higher dollar impact on the typical American family than the same 10 percent price increase for electricity. Consolidation will likely increase the frequency and frustration levels expressed in consumer complaints. While this is not an argument against consolidation, it is a valid consideration.

Consolidation is also indirectly tied to deregulation. While mergers are not any more or less likely to occur between companies in states where deregulation exists, the less-than-superlative performance of deregulation and retail electricity markets will exert some measure of anti-consolidation sentiment.

The lack of interest from the major oil and gas companies raises a caution flag for consolidation. True, Conoco, ExxonMobil, ChevronTexaco and others have been burned by their investments in the coal and power sectors in the past. Flush with cash, however, one would think that the majors would consider something in the utility sector to be a worthy long-term investment vehicle in light of depressed power prices, rising natural gas demand (a natural tie to the majors’ interest in liquefied natural gas), and steady economic growth. To date, the rumor mill has been surprisingly quiet. Maybe the majors are leery of the possible public and political fallout from a foray into the power sector…or maybe they’re telling us something about consolidation in the current environment.

Further, while PUHCA repeal would eliminate some of the roadblocks to industry consolidation it’s not a cure-all for beneficial consolidation. More importantly, it’s by no means certain. For those of you who read this column regularly, you know my faith in Congress’ ability to pass an energy bill of any sort, not to mention one with provisions to repeal PUHCA, is marginal.

Don’t mistake my message here. I am firmly convinced that merger and acquisition activity will pick up in coming years. The Duke/Cinergy and Exelon/PSEG deals plainly support that conclusion. The unique nature of the power industry, however, will prevent – or at least slow – the creation of an industry dominated by a handful of super-utility companies. p