Energy markets: Start practicing your foreign languages. Consolidation underway sees national boundaries as a mere inconvenience, dwarfed by tough financing markets and over-regulation.  However, regulatory winds blow in multiple directions, seeking to advance policy goals as varied as energy markets that are both green and un-bundled (more on both of these points below).  The M&A markets are taking the hint, with a raft of green-focused energy M&A deals, most recently the north European link up between Vattenhallen and Nuon. With the Obama Administration using both its budget and the American Recovery and Reinvestment Act (ARRA) to shape-shift the energy industry, the U.S. is looking to play fast catch-up.

M&A within the energy industry (both the power generation and distribution sectors, including utilities, pipelines, and wires) is holding up exceptionally well, with $394 billion worth of transactions within the last 12 months. In the coming years, M&A activities may heat up even further as energy independence and “green collar” jobs remain the mantras of both Washington and Brussels.  Of note – and an interesting lesson in strange bedfellows – nuclear energy is considered by many today to be alternative or even “green” (sans smirks). 

This M&A activity on both sides of the Atlantic is energized by legal issues – including factors that range from regulatory, to governance, to the contract terms shaped around ever-concerning financing markets.  Most recently, this list has been supplemented with one other legislative factor – the ARRA or, in common parlance, the Obama Stimulus Package.  With its interest in driving alternative energy via a range of legal and tax incentives, this is the latest of the legal stimuli encouraging energy market M&A. 

Regulatory issues play a dominating role in the energy markets.  There are two titans of power regulation (indeed regulation in general) – the U.S. and European Union (EU).  Their central roles are illuminated by Électricité de France’s (EDF) $4.5 billion acquisition of half Constellation’s nuclear power arm. Constellation was one of the earliest casualties of the credit crisis. The company nearly became insolvent due to exposure to Lehman Brothers. So EDF, after thrusting aside a competing offer from a Berkshire Hathaway unit, stepped into the breach and offered to split Constellations’ nuclear operations 50-50. However, anything with the world “nuclear” in it tends to invite scrutiny and regulation. Hence, the deal is structured to withstand review by the U.S. Nuclear Regulatory Commission (NRC). Foreign-owned companies are prohibited from “owning, controlling or dominating” any company that has a license to operate a nuclear reactor in the U.S. Still, scrutiny comes with power, and Constellation’s ownership of Baltimore Gas & Energy (BGE), a public utility which is unaffected by the transaction,  has drawn the attention of the Maryland’s Attorney General’s Office. The Maryland Public Service Commission plans to consider whether it has authority to review the transaction later this month. 

Regulatory issues have often stymied hostile M&A in energy, even if corporate governance advocates would have it otherwise. In particular, state regulations are one of the reasons that hostile transactions are very unusual in the power industry. Still, that didn’t stop Exelon from going nuclear on rival NRG – the former is the largest U.S. producer of nuclear power and latter is also active and expanding within the space. Exelon launched what was then a $6.2 billion exchange offer and a proxy contests for NGR late last year. Exelon recently announced more than 51% of its target’s shareholders have agreed to tender. However, NRG is refusing to come to the table citing the low price and, as is often the case in hostile takeovers, the deal is conditioned on financing.

Governance issues complicate matters here, focused particularly both on constraining “change in control” provisions and the general reluctance of corporate boards to be taken out. NRG has gone as far as announcing on Monday that it has agreed to acquire Reliant Energy’s Texas retail power operations for $287.5 million. NRG claims that the $200 million worth of debt financing the transaction is not intended to make company a less attractive (i.e., more leveraged) takeover target. There is also a little problem with a “change in control” provision in $4.75 billion of NRG’s senior notes that a hostile takeover would trigger. Nonetheless, Exelon has already applied for approval of the transaction with federal regulators and believes it can attain regulatory approval with or without the cooperation of NRG. Sagging asset values and a market starved for alternative energy sources can lead to hostile takeovers even in what is usually an amicable market.  

However, regulation doesn’t always block mergers – sometimes its cause them. Evidencing deregulatory zeal, the EU has focused on creating a common and free market in energy, which has unleashed a flurry of M&A within the sector.  In particular, the EU radically altered the profile of its energy markets with privatization and “unbundling” directives (requiring vertically integrated companies to divest of generation or distribution assets). The recent headline grabber was last week’s announcement by Vattenhallen, a Swedish-based but pan-Baltic power company, to purchase the power generation of Nuon for 8.5 billion Euros. The deal, prompted by a government mandated restructuring of Dutch power industry, will greatly increase Vattenhallen’s renewable energy portfolio, which is in no small part due to Nuon’s ownership of Europe’s biggest offshore-wind operator.  The deal does not include Nuon’s grid company Alliander.  As a testament to the importance of financing markets (and the limitations thereof) Vattenhallen plans to divest its north-German distribution grid to help finance the transaction.

The U.S. is just starting to warm up to alternative energy, and alternative markets relating to energy.  Europe is, by comparison, well-heated by both. First, the new Obama budget calls for billions in new spend for renewable sources of power to cut emissions.  Second, the creation of a new energy-driven derivatives market (in carbon emissions) is another game of cross-Atlantic catch up of legal and market infrastructure.  In particular, President Obama’s recent budget calls for an extensive cap-and-trade program that will charge green-house gas trapping industries such as: oil, electric power, and heavy industries. The ARRA includes almost $60 billion in tax incentives, grants, loans, loan guarantees, and related initiatives intended to spur the growth of alternative energy. The federal money is supposed to act as bridge loan of sorts until the markets find terra firma and include everything from massive smart energy grid infrastructure to local home weatherization projects. All the federal money floating around should also help spur a little more M&A.

Energy M&A promises to be driven by government actions (of both the regulatory and deregulatory varieties), along with alternative energy impulses around the world going forward. The structure and terms of this M&A activity will be further shaped by depressed asset prices, depressing financing markets and gyrating energy prices.  As big energy deals (and any follow-on infrastructure development) are dependent on financing, look for financing terms in particular to continue blowing with the winds.

Published: March 3, 2009