Many in the energy industry are anticipating a wave of mergers that will fundamentally
alter and concentrate the energy industry, both from utility consolidation and
mergers between utilities and firms from other business sectors. Warren Buffett,
for example, acquired MidAmerican Energy five years ago, announced the acquisition
of PacifiCorp last year and recently declared, Well be looking for more.
The number of utilities has been shrinking for years, as those that remain have
gotten larger, and the Energy Policy Act of 2005 (EPAct 2005) has removed one
of the significant obstacles to further consolidation, largely through the repeal
of the Public Utility Holding Company Act (PUHCA) of 1935. The Federal Energy
Regulatory Commission (FERC) has taken on additional merger oversight responsibilities
as a result of these changes and the role of the Securities and Exchange Commission
has been greatly diminished. In addition, EPAct 2005 has also eased restrictions
against ownership by firms that are foreign owned or involved in different industries.
While PUHCA is gone, state legislatures and the various state commissions may
step up to fill the void. The greatest uncertainties over the degree of consolidation
relate to state-level activism. States actions will impose costs on the merging
parties and as a result will play a major role in determining just how much
Under PUHCA, the geographic scope of businesses that could be owned by holding
companies was limited to those that could be operated as a single integrated
system. Companies were quite often restricted to either operations within a
single state or to interconnected utilities across state lines. While there
had been some success in pushing the geographic envelope AEPs Texas-to-Michigan
and Exelons Illinois-to-Pennsylvania systems come to mind gaining regulatory
approval of these kinds of mergers was a challenge. Actions taken to increase
the interconnectedness of the merged entity (which might also be tied to increased
efficiencies) could aggravate market power concerns. Thus, merging parties were
caught between two contradictory regulatory objectives: They had to show they
were part of an interconnected system while also demonstrating that market power
was not an issue.
While the number of publicly traded regulated electric utilities in the United
States has dropped over the last 15 years, it is still remarkably large when
considering maturity and capital intensity of the industry. Benefits from consolidation
may include general scale economies from larger operations, reduced overhead
costs, better access to capital, better access to technology and an ability
to manage risk differently. Some smaller companies may be prime takeover targets
due to higher costs, due to factors such as the requirements imposed under Sarbanes-Oxley,
which disproportionately affect these smaller utilities.
In theory, reduced restrictions on mergers may open up opportunities for risk
management that previously had been limited. The combination of utilities in
different geographic locations provides an opportunity to diversify weather
risks (extreme temperatures and storms) as well as regulatory risk. Ownership
affiliations with major oil, gas and coal firms could provide much more sophisticated
risk management of fuel supplies and their costs. Increased scale may provide
benefits in energy supply management and large-scale power plant ownership.
Nevertheless, exploitable efficiency gains through merger are not necessarily
clear with the repeal of PUHCA, especially with the associated regulatory burdens.
The current structure of regulated utilities is a reflection of the balkanized
state of regulation itself. The ultimate effect on the multitude and form of
mergers depends upon the regulatory review of proposed combinations in the post-PUHCA
environment compared to the environment prior to repeal. This comes down to
the way in which FERC and the states will handle utility mergers. FERC seems
poised to view utility mergers in a manner generally consistent with its rulings
in the past. State legislatures and public service commissions, however, are
re-evaluating their role and objectives in merger reviews. There are indications
that states are concerned with the possibility of substantial consolidation,
and may take actions in the interest of protecting consumers.
FERCs Expanded Role
FERC is preparing for the review of a larger number of mergers than it had
in the past, expecting to receive eight in both FY 2006 and FY 2007, up from
4 in 2005. EPAct 2005 amends Section 203(a) of the Federal Power Act to grant
FERC the authority to approve public utility and holding company transactions
involving a target (including generation facilities) with a value of more than
$10 million. In doing so:
After notice and opportunity for hearing, the Commission shall
approve the proposed disposition, consolidation, acquisition, or change in control,
if it finds that the proposed transaction will be consistent with the public
interest, and will not result in crosssubsidization of a non-utility associate
company or the pledge or encumbrance of utility assets for the benefit of an
associate company, unless the Commission determines that the crosssubsidization,
pledge, or encumbrance will be consistent with the public interest. [emphasis
The public interest standard is consistent with FERCs rules in the past
regarding merger approval. In applying this standard, FERC has evaluated a transactions
effect on competition, rates and regulation. In reviewing mergers, FERC follows
the Department of Justice (DOJ) and Federal Trade Commission (FTC) Merger Guidelines,
and has used an analytic tool of its own device (i.e., its Appendix A Analysis)
to apply to utility mergers.
In addition to the public interest standard, FERC must find that the acquisition
will not result in a cross-subsidization to an associate company unless that
cross-subsidization is in the public interest. Cross-subsidization can occur
when a regulated company shares administrative, capital or operating costs with
an unregulated company. FERC will be tasked with determining when cross-subsidies
are in the public interest and when they are not. Presumably, merging companies
will be pressed to demonstrate how efficiency gains from cross-subsidies will
benefit consumers, or how these cross-subsidies otherwise are in the public
Under the new legislation, FERC is mandated to act within 180 days of a filed
application, and is to adopt procedures for the expeditious consideration of
applications. While this review period is longer than the 60 days typically
required of DOJ and FTC, specifying a time for review is a positive step to
ensuring that merger applications are evaluated relatively quickly and companies
are not left in limbo awaiting regulatory approval. In practice, FERC may receive
additional time from the merging parties if the transaction is particularly
large or troublesome, much as merging parties often grant the DOJ or FTC additional
time if requested.
While FERCs responsibilities have increased, recent changes build on a long
history of merger oversight. That does not mean that everyone will be content
with the scope of FERCs oversight or its judgment in applying the public interest
State Merger Activism
The states have long been integral to any merger approval and the recent regulatory
changes have, if anything, increased their role. While each state has its
own requirements, the state commissions role as the approver of retail rates
ensures involvement in any merger involving state-regulated utilities.
Merger announcements are often coupled with assertions of synergies and efficiencies.
It does not take long for state commissions to ask, Whats in it for ratepayers?
Many mergers have been approved once tied to a period of guaranteed rate reductions
but this increases the cost of the merger. Rate reductions might be paid for
out-of-operational cost savings, but predicted efficiency gains are uncertain.
Merger benefits could arise from risk sharing between formerly separate entities
but such benefits may be hard to capture when the entities are separately regulated.
After all, some benefits are present only when unexpected losses in one area
can be offset by gains from another. Only a very disciplined and optimistic
state regulator would be willing to allow ratepayers in his state to bear financial
burden from problems elsewhere (outside of his state) in the hopes that the
favor would be returned some day if fortunes were reversed. Such hypothetical
risk sharing is even more unlikely to be approved by state commissions if a
merger is contemplated between regulated and unregulated affiliates, such as
between an electric utility and a fuel company.
State commissions have a long history of concern about the potential consequences
arising from consolidation between utilities and unregulated companies. Commissions
have focused concern on the possibility that the finances of the regulated utility
would be jeopardized by an unregulated affiliate. Unregulated businesses are
often riskier and in any event are largely outside of the state commissions
control. In evaluating the risk management issues involved in a potential merger,
commissions also may focus on issues such as transfer pricing, crosssubsidization
and financial abuse arising post-merger.
Transfer pricing involves the setting of prices for any good that passes between
regulated and unregulated (or separately regulated) entities. Consumers can
be harmed if transfer prices are higher than market rates and the utility attempts
to capture these prices in the rate base. Crosssubsidization concerns may arise
if companies share operating, administrative or capital costs. Limitations on
cross-subsidies may mitigate potential efficiencies from size or scope, preventing
a reduction in capital costs for the merger entity, for instance.
The states are showing no indication of backing away from these issues. States
are considering instituting increased authority in reviewing mergers and oversight
of holding companies following the repeal of PUHCA. Laws to increase this state-level
authority are being referred to as mini-PUHCAs, and it is possible that they
could have a stifling effect on consolidation similar to that of the original
While so-called mini-PUHCAs may give states additional access to holding companies,
it is not clear the extent to which they will be employed or persist. In a recent
conversation, Robert Burns of the National Regulatory Research Institute said
Mini-PUHCAs essentially allow a state to reach into the holding company itself
but potentially violate the intent of Congress to encourage investment in utilities
and their infrastructure.
States seem to be considering ring fencing as a viable tool to mitigate undesirable
consequences from the combination of regulated and unregulated businesses. Ring
fencing is designed to protect a regulated company from unregulated affiliates
via certain restrictions such as capital structure requirements, independent
boards and investment restrictions on the unregulated entity.
Many states may not be able to require ring fencing of merging parties given
their current laws and regulations. The National Regulatory Research Institute
has identified only three states Wisconsin, Virginia and Oregon that have
regulatory tools at their disposal sufficient to insulate regulated utilities
from nonutility affiliate undertakings. In the face of new complex mergers,
many states may beef up their ringfencing authority.
However, overly aggressive ring fencing could erase efficiencies contemplated
by a merger. In a situation where there are no clear, large efficiency gains,
merging entities may not be willing to promise large benefits to state commissions,
especially when facing additional restrictions from states that may erode the
very benefits in which states may seek to share. This combination of circumstances
may dissuade a number of potential mergers.
Looking Forward Industry Perspectives
The prevailing view seems to be that repeal of PUHCA will increase the number
of mergers and introduce additional regulatory complexities:.
- A decade from now, the total number of investor-owned utilities will be
way down, the American marketplace will be far more internationalized, and
there will almost certainly be more unbundling of assets to minimize negative
impacts of the market power problems these large mergers will create, says
Roger W. Gale, CEO of GF Energy.
- The effect will likely be greater consolidation of the electric industry,
greater concentration of ownership, more complex company structures, and more
opportunities for the exercise of market power . Greater concentration in
ownership of generating assets will only add to the structural problems, increasing
the potential for market manipulation, the American Public Power Association
- Due to the repeal of the PUHCA discussed above, FERC and state commissions
can expect more mergers and acquisitions, many of which may involve diversified
activities within holding company structures, The National Regulatory Research
Institute has stated.
Some energy company executives expect further consolidation but largely as
a result of other pressures in the industry, and not directly, as due to the
repeal of PUHCA. And while some feel consolidation will occur within the regulated
utility sector, they do not see a wider formation of conglomerate mergers, even
within the energy industry.
- I believe that there will be further consolidation. I dont know that the
repeal will have much to do with it. There will obviously be a positive impact.
But I think many companies, if you look at Warren Buffett, Duke, and others,
have been ignoring the holding company act already, says Warren Robinson,
Executive VP and CFO of MDU Resources.
- I dont think the problem was PUHCA. Running power plants is really not
what oil companies do. And you also have even though you are allowed to
do it you do have the rate regulation problem. Most oil companies dont
like any more government regulation than they currently have, says Stephen
I. Chazen, Senior Executive VP and CFO, Occidental Petroleum.
The impact on consolidation by the repeal of PUHCA, increased regulatory authority
of FERC and potential for states to shift their focus is unclear. We might see
some additional combinations designed to diversify geographically, and additional
conglomerate mergers. Much of the impact will depend on the extent to which
states step in to fill the perceived void left by the repeal of PUHCA.
While it might be tempting for companies to wait and see to what extent states
will be proactive in merger review, some more-daring companies might initiate
mergers while state commissions themselves are unsure about what authority they
possess. Of course, no company wants to be a test case resulting in a long drawn-out
fight at the state level. Regardless, merging parties will likely be asked to
provide assurances to states in which they operate, and states will carefully
assess mergers that appear particularly complex. This alone will temper potential
consolidations contemplated as a result of the repeal of PUHCA.
This article does not represent the views of LECG or other experts at LECG.
- Berkshire Hathaway Annual Report, Letter to Shareholders, February 28, 2006,
- FY 2007 Congressional Performance Budget Request, Federal Energy Regulatory
Commission, February 2006.
- Energy Policy Act of 2005, Section 1289, Merger Review Reform.
- The EPAct 2005 has explicitly increased the authority of the states by explicitly
permitting them to gain access to holding-company records, including associate
companies and affiliates.
- Briefing Paper: Implications of EPAct 2005 for State Commission, The National
Regulatory Research Institute, October 2005, p. 7.
- Gale, Roger W., What the New Mergers Will Mean, Energybiz Magazine, July/August
- The Electric Utility Industry After PUHCA Repeal: What Happens Next? American
Public Power Association, October 2005, p. 1.
- Briefing Paper: Implications of EPAct 2005 for State Commission, The National
Regulatory Research Institute, October 2005, p. 8.
- Stravos, Richard, CFOs Speak Out: Looking Beyond Power, Public Utility
Fortnightly, October 2005.