Trends in three areas could determine whether the Q3 spike in US power M&A is sustainable

Regulatory uncertainty, the drive toward consolidation and the constant pressure to innovate will shape dealmaking

M&A activity targeting the US power and utilities sector experienced a rebound in activity during Q3 following a poor-performing second quarter. A total of 27 deals valued at US$33.9 billion was a sevenfold increase in value compared to Q2’s figure and the third highest quarterly value on record.

A slew of lapsed deals and mounting regulatory pressure had suppressed sector dealmaking earlier this year. We consider trends in three areas that could help determine whether M&A activity will remain robust for the rest of 2017 and into 2018.

Regulatory uncertainty

Regulation can be a huge challenge for dealmakers in the US power and utilities sector, as was clearly seen in the third quarter. Great Plains Energy’s US$12.2 billion takeover offer for Westar Energy, Kansas’s largest electricity operator, lapsed in July, and Berkshire Hathaway Energy’s US$16.7 billion bid for Texas utilities firm Oncor hit the buffers in August.

Since the beginning of his administration, President Trump has made it a priority to eliminate federal regulations perceived as burdensome to the fossil fuel industry. Recently, the Trump administration announced it would take formal steps to repeal the Clean Power Plan—one of President Obama’s signature policies—which aimed to reduce emissions from electric power plants, particularly by encouraging states to reduce their use of coal in generating power. (Due to litigation, the Clean Power Plan had never gone into effect).

Some observers credit deregulation in part for the strong quarter and expect the good times to roll on, but others fear that uncertainty around deregulation could actually harm dealmaking in the long run.

Moreover, Secretary of Energy Rick Perry recently proposed the Grid Resiliency Pricing Rule, which asks the Federal Energy Regulatory Committee (FERC) to guarantee full cost recovery in organized power markets for certain “fuel-secure generation units” that provide grid reliability and resiliency. It is generally accepted that the Department of Energy formulation of the rule aims to improve the market position of coal-fired and nuclear power plants, but it is unclear whether FERC, which must consider the rule but not necessarily approve it, will agree that a major change to price formation in the wholesale power markets is necessary.

Uncertainty stemming from these and other regulatory developments will make it difficult to value generation assets in the near future, and could stall M&A as the markets settle in response to the administration’s proposals.

Market consolidation

US electricity demand is stagnant, having peaked in 2007 before efficiency measures and a weaker economy took hold. Given the challenges to organic growth, particularly for traditional power generators, there is a strong argument for M&A within the US power and utilities sector.

The drive for consolidation was evident in Q3. Sempra Energy announced its US$9.45 billion plan to acquire Energy Future Holdings, 80 percent owner of Oncor Electric. (The actual transaction price is more than US$18 billion when two additional factors are accounted for: Oncor’s debt and the 20 percent of Oncor that Energy Future Holdings doesn't own). Private equity firm Energy Capital Partners spearheaded a consortium to buy US power generator Calpine for US$5.6 billion (US$17 billion including debt).

But a number of deals were blocked or delayed by regulators earlier this year, which raises questions about regulators’ tolerance for consolidation. NextEra’s US$2.6 billion bid for Hawaiian Electric Industries was blocked in July on the grounds that the deal wasn’t in the public interest. In April of this year, the planned US$12.1 billion merger between electrical utility rivals Westar Energy and Great Plains Energy was blocked by Kansas regulators because the purchase price was too high. And in the second quarter of 2017, NextEra’s bid for Oncor Electrical Delivery was blocked by Texas regulators on the grounds that it removed ring-fencing measures set up to protect Oncor’s credit rating.

Warren Buffet, among others, has lauded utility firms as businesses that require routine investment but also generate consistent returns for buyers. The need to boost profits and provide strong returns to shareholders should continue to drive consolidation within the sector, if regulators allow deals to proceed.

Technology innovation

Consumers have grown to expect power companies to develop sophisticated digital services akin to those that have revolutionized other industries, and the industry is undergoing a seismic shift as power companies seek to transform and reinvent their business models.

This has led to the rise of “grid-edge” technologies, a phrase used to describe smart and connected technologies that are installed at the edge of the electric power grid. These include grid sensors, distributed generation, battery generation, smart meters, smart appliances and electric vehicles.

Artificial intelligence (AI) is also taking hold in the power and utilities space. AI firms such as Grid Edge allow customers to “predict, optimize and control their energy profile” using machine learning technology.

Many power companies and utilities do not have the in-house capabilities to pursue digital strategies, and they may turn to acquisitions and joint ventures to adapt to changing sector dynamics and evolving consumer demands.

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