May 07 - Business Week

Residents of New York, Maine, and Houston have something in common they may not realize: When they pay their electric bills each month, the money ends up in the coffers of some of Europe's largest utilities.

From Britain to Germany to Portugal, big producers and distributors of gas and electricity are looking for growth by expanding out of their home markets. One of the juiciest opportunities lies across the Atlantic, in the huge and fragmented U.S. utilities market, where there are still about 60 separate operators ranging in size from rural collectives to giants like Pacific Gas & Electric (PCG).

The move stateside makes sense for the Europeans. Utilities such as France's electricite de France (EDF.PA) and Germany's RWE (RWEG.DE) already have scooped up smaller local competitors over the last 10 years, leaving the continent dominated by handful of companies. Often shielded from foreign rivals by local governments, the companies now have few options left in Western Europe to invest their expanding capital reserves and satisfy shareholders pushing for profit growth.

U.S. Has Most Opportunities

The U.S. also offers some unique advantages. Analysts say the market is still crying out for consolidation, despite a decade of mergers that already has halved the number of utility players. Plus, the U.S. remains more open to foreign ownership than some other growth markets, such as Russia and China, and has a track record of regulatory stability that companies value in making long-term investment decisions.

"The U.S. is the most opportune place for European players to expand," says John McConomy, a partner in the U.S. Power and Transaction practice of PricewaterhouseCoopers [PwC]. "They're cash rich, already consolidated in Europe, and have a good track record at generating revenues, particularly from renewables."

The European push into the U.S. may face a few snags along the way. Any would-be acquirer must get approval from federal, state, and local regulators, a complicated task that already has delayed a $4.5 billion takeover by Spain's Iberdrola [BusinessWeek.com, 06/06/07] (IDRO.BE) of electricity and gas provider Energy East (EAS), based in New Gloucester, Maine. Although the U.S. market is stable and safe, it's also relatively slow-growing, with annual revenue increases often as low as 1%. And with utility earnings typically capped by regulators, the business could become less attractive if lawmakers force utilities to ramp up their investment in costly renewable technologies.

Value of M&A Transactions

So far, these potential drawbacks aren't slowing the mergers and acquisitions wave. According to PwC, the number of U.S. electricity and gas deals rose 15% last year, to 146, and the value of M&A transactions soared 61%, to $87.5 billion despite the second-half credit crunch.

The $43.8 billion private-equity-led acquisition of Texas utility TXU [BusinessWeek.com, 02/26/07] dominated last year's activity, but European players also got in on the action. Portugal's Energas de Portugal (EDP.LS), for example, paid $2.3 billion in May, 2007, for Houston-based Horizon Wind Energy, and Germany's E.ON (EONG.DE) forked out $1.4 billion in October, 2007, for the North American operations of Irish renewable company Airtricity.

Few European companies have embraced the U.S. market as wholeheartedly as Britain's National Grid (NGG), which grew out of the privatization of Britain's energy sector in the 1980s. Specializing in electricity and gas transmission and distribution, the dual-listed company first crossed the Atlantic in 2000 when it gobbled up a string of small utilities in New England. National Grid generated 50% of its $17.2 billion in 2007 revenues from its New England businesses.

National Grid upped the ante last year, paying $7.3 billion for Brooklyn's KeySpan to increase its customer base to 7 million across New York, Massachusetts, New Hampshire, and Rhode Island. After the deal, National Grid jumped to the second-largest player in the U.S. by number of customers, and the largest company in the Northeast in both electricity and gas transmission.

According to Tom King, National Grid's executive director of electricity distribution and generation and the former president of PG&E, the company's ability to navigate the local regulatory minefield has been key to its success in North America. That has involved everything from calming local concerns about the environmental impact of new facilities to winning over skeptical state regulators who first balked at a European company buying domestic assets. "Understanding the U.S. culture has been critical," he says.

Going Green Could Undermine Profits

Now National Grid is on the lookout for further acquisitions. While it won't comment on possible deals, the company wants to increase its footprint in the U.S. by 25% over the next four years through organic growth. "There's real opportunity to create value," says Nick Winser, National Grid's director of British and U.S. transmission operations.

The biggest question about continued U.S. expansion for European utilities is the possibility that pressure to go green could undermine future profits. Most U.S. jurisdictions enforce stringent rate-of-return caps that force utilities to return profits to customers if they exceed yearly targets. That helps prevent monopoly profit-taking, but can throttle risky investments in new technologies -- especially renewables such as wind and solar.

These profit restrictions also could lead European players to turn their attention to less stable but faster-growing markets in Eastern Europe and Russia. In 2007 alone, 5 of the 10 largest electricity and gas deals involved Russia companies. E.ON, for instance, paid $8.4 billion in September, 2007, for Russian energy company OGK-4, and Italy's ENEL (ENEI.MI) spent $6.2 billion in June, 2007, for utility OGK-5.

Looking at Riskier Markets

Doug King, vice-chairman of the energy, infrastructure, and utilities team for Britain at Deloitte Consulting, figures such deals can offer rates of return as high as 7% to 8%, vs. the 1% to 2% typical for U.S. acquisitions. With that much upside potential some European utilities are willing to risk their capital in a country with a track record of regulatory uncertainty. "The Russian market is huge," King says. "Unlike other parts of the economy, investing in the Russian utilities sector seems to be acceptable."

That said, recent skirmishes in Russia's oil and gas extraction sector have demonstrated that the rules of the road can shift quickly for foreign investors. That may persuade European utilities to forgo the potential riches of the East for the safer, more stable profits on offer in the U.S.. Cash-rich and hungry for growth, the U.S. market may be just what's needed to keep Europe's utilities powering ahead.