Consolidation in the Regulated Electricity Sector is Accelerating

Circumstances are converging to encourage consolidation in the electricity sector. Electricity businesses are gaining attention from investors as attractive M&A targets. Particularly on the transmission and distribution side, these highly regulated businesses tend to deliver predictable returns that are attractive in low-interest-rate markets.

Concurrently, many electricity businesses are owned by governments that face growing pressure to find efficiencies and new sources of money to fund infrastructure spending, increasing the likelihood that the business will become available for acquisition. The combined influence of these factors is starting to be felt.

Investor Demand

Electricity transmission and distribution businesses are gaining in popularity as targets for acquisition. Fortis Inc., an integrated electricity utility company that had its beginnings as a Newfoundland transmission and distribution business, acquired CH Energy Group in 2013 and UNS Energy in 2014, which operate regulated electricity and gas distribution businesses in the United States. In 2014, Berkshire Hathaway purchased AltaLink from SNC Lavalin in a transaction that placed a higher value than expected on the Alberta transmission assets, demonstrating the attractive prices that the private sector is prepared to pay for these assets. And recent transactions are also demonstrating the potential that these businesses have to grow: in September 2015, Nova Scotia-based energy company Emera Inc. announced its intention to acquire TECO Energy, a U.S. power generation business.

Appetite to Consolidate

Governments looking to dispose electricity-sector assets are also generating M&A activity. Many government-owned electricity distributors lack the capital and other resources necessary to adapt to change and increase efficiency—and in some regions, the government is creating incentives to accelerate the consolidation process. In the spring of 2015, the Province of New South Wales in Australia obtained a mandate to lease a 49% stake in its transmission and distribution network to fund new investment in infrastructure. The government is rumoured to have received interest from a number of pension and other offshore investors.

The Canadian electricity landscape is also seeing movement toward consolidation. In 2014, the Ontario provincial government struck the Premier’s Advisory Council on Government Assets, chaired by Ed Clark, which recommended a number of changes to generate funds for infrastructure development and spur consolidation in the electricity distribution sector (read our interview with Ed Clark below). Following those recommendations, on November 5, 2015, the Province of Ontario in Canada sold a 15% interest in its transmission and distribution business by way of an initial public offering of the shares of Hydro One Limited to fund infrastructure investment.

M&A in the Regulated Electricity Sector: What are the Challenges?

As is the case in many other highly regulated sectors, M&A in this sector poses unique tax, regulatory and other challenges (see Trend 3, “New Investors, New Scope: Infrastructure Investing is Broadening”). For example, Ontario’s payment-in-lieu tax provisions for municipally owned utilities have generally discouraged consolidation. To address this concern, the government has temporarily reduced various tax components to further foster consolidation.

Where the assets are owned by municipalities or other governments, the political approval process may introduce uncertainty and timing challenges. Also, because electricity transmission and distribution businesses are largely rate-regulated, parties must pay careful attention to the impact of the transaction on ratepayers. The rate-setting process is critical to value, and the ability of an acquiror to retain the benefit of synergies, harmonize rates and grow the rate base can have a significant effect on the economics of the deal.

In many cases the acquisition itself may also require approval by the rate regulator. As well (as was the case for Berkshire Hathaway’s acquisition of AltaLink), foreign investment and anti-trust approvals may be necessary. The regulatory approval processes in Canada, the United States and elsewhere can be prolonged, requiring careful negotiation of terms to facilitate the approval process and fairly allocate between the parties the risk of a failed approval or unacceptable terms being imposed by a regulator.

Conclusion

The growing number of investors amenable to taking on the regulatory challenges of businesses in the electricity sector speaks to the appealing characteristics of these assets, such as stable long-term returns. In the year ahead, we expect to see factors unique to regulated regimes continue to converge with investor interest to fuel M&A activity in this space.