During February the UK electricity market was the focus of merger and acquisition activity. In a seven-day period one utility, one supply business and a generator were all the subject of acquisition talk. Add to this the Seeboard business of AEP, which will be sold as individual supply and distribution businesses to maximise the total value of the asset, and the UK market could put the 'For Sale' signs up. It is easy to see why the UK is an attractive market for foreign investment - it is the most competitive in the European Union for gas and electricity. But equally, it is the success of market competition, which is encouraging companies to consider selling assets.
Take Innogy Holdings, which is subject to a friendly bid by Germany's RWE. The company has grown through acquisition to take advantage of market competition and to build a critical mass of over 5 million customers, but with margins wafer thin and heavy debt from funding its acquisitions it is highly receptive to selling out. Certainly the market agrees with such a decision as Innogy's share price rallied 20 per cent on the news of the bid interest.
Next take Amerada Hess' gas and power business, which was sold to TXU this month. With just under 500 000 customers it has probably grown as far as it can without acquiring another supply business and has accrued debts of £47m. Nevertheless the value of the business on a cost per customer basis was around £300. Compare this to the last supply business acquisition, Centrica's purchase of Enron Direct at around £200 per customer. Even allowing for the special factors surrounding the sale, it is clear that acquisition prices for customers are increasing markedly.
Now take the sale of Drax. Although AES has since denied earlier rumours that it was putting the coal-fired plant up for sale to reduce debts it is interesting to compare the price AES paid for the plant in 1999, £1.8bn, against the likely offer price today of £800m. In other words the value of the plant has depreciated by 44 per cent, or around 15 per cent per year.
It is this scenario of highly valued customer business versus depreciating generation assets, which is driving the market, and the catalyst is competition. In 1997, before full market competition in gas and electricity the wholesale price of gas was between 8-11p/therm, while baseload electricity was as high as £32/MWh. These prices indicate a spark spread of around £24/MWh and gave a strong incentive to build generation plant. But in the five years since, during which market competition has intensified, the prices have changed dramatically. At one point the spark spread was a negative figure and today is around £3.50/MWh. Clearly these levels discourage investment in new plant and even question whether the plant is economically viable to keep on line. AES, for example, shut down its 363MW plant in South Wales in response to bearish electricity prices at around £15/MWh.
While the onset of full competition saw a move to form vertically integrated utilities the mood today is characterised by investment in customer bases and divestment of generation plant. But is this the right approach? If prices can move so dramatically in the period 1997-02 then surely they can move by a sizeable magnitude during the next five years. Competition will, at some point, reach maturity. At this stage the price can no longer move any lower. Indeed, with the UK government's commitment to renewable energy investment it is already clear that the general direction for prices will be upwards. If we assume that gas prices increase proportionately less than electricity prices - a valid assumption before the UK becomes a net importer of gas - over the next 2-5 years then the spark spread will widen out. Indeed some analysts forecast that the spark spread could widen out to £10/MWh within the next few years. At this point generation assets start to appreciate in value.
As the market moves through another bout of merger and acquisition activity the issue to be addressed is whether this is a short-term or long-term view. While a number of generating companies may be feeling financially vulnerable at present the potential for a reversal of fortunes during the next few years is highly persuasive.
But if these companies sell off generating assets now, at highly depreciated prices, will they be able to buy them back at much higher prices when the market recovers? Or will they effectively be priced out of the market? Another question being pondered in the market is the value of electricity assets. Conventional wisdom suggests that trading of electricity is made easier with underlying physical assets, but this is not necessarily the case. TXU Energi has adopted a strategy of divesting much of its generation plant but this has not impacted on its trading efficiencies and effectiveness. Indeed the company has adopted an innovative approach by developing a virtual generation model to enable it to trade electricity without recourse to physical assets.
What is clear is that competition is altering the trading paradigm. While this is most acute in the UK market, which has the most advanced competition in gas and electricity markets, the other European markets will not be far behind. As competition progresses towards maturity the value of customer assets will continue to appreciate at a faster value than generation assets and this apparent dislocation in value will drive the business strategies of utilities.
But when competition reaches maturity, assisted by the eventual full liberalisation of the European Union market, the relationship between customer and generation assets may well be reversed.
For companies active in the electricity market, as well as those planning an entry strategy, consideration will have to be balanced by short and long-term strategies.
If companies believe their business prospects are best supported by generation assets then the time to invest is now. In doing so they will have to be prepared for some short-term financial pain but the longer-term prospects may well outweigh any short-term suffering.
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