Nicholas Watson in Prague -

The Czech utility CEZ is expected to sign on Monday a power plant deal with the Bosnian Serb Republic, adding yet another name to a long list of acquisitions that have made 2006 a record year for mergers in Europe's energy sector. And despite the loud disapproving noises coming out of Brussels about this consolidation, 2007 is expected to see more of the same.

According to the financial data provider Dealogic, in the year to the end of November there were 334 deals announced by European utilities worth a total $187.5bn. That compares with 304 deals announced in 2006 worth $123.8bn and 307 deals in 2004 worth $54.7bn.

Hardly a month goes by without at least one utility merger being proposed. The latest CEZ deal, in which it will acquire an existing plant with a 300-megawatt (MW) capacity and coal mines with 400m tonnes of reserves in return for investing €1.5bn to construct a 660MW coal power plant in Gacko, is actually only one of two deals that the Czech utility is looking at in the country.

According to sources, CEZ is looking at a similar opportunity at the Ugljevik plant in the Bosnian Serb Republic, where CEZ is competing against Slovenia's EPS and a Greek investor. However, the sources say this is more of a longer-term proposition, with the government looking to see how the Gacko deal develops before pressing on.

CEZ's chief executive, Martin Roman, said that in all his firm is planning to spend around €10bn on acquisitions by 2009, with the company looking to close deals soon in Ukraine and Russia.

The driving force behind these deals and the others in the region is, of course, the liberalisation of the region's electricity and gas markets. This is supposed to come to a head in July of next year when all consumers, retail and business, within the 25 states of the EU should be able to choose their electricity and gas suppliers. This new competitive environment is limiting companies’ ability to grow organically, forcing many to look at M&A to deliver this growth instead.

Cart before horse

Part of the reason that organic growth in utilities is so difficult is down to the way that the EU implemented its grand liberalisation project. According to Dieter Helm, an Oxford fellow in economics and advisor to the UK government on energy policy, the EU has been guilty of forcing through the competition before building the interconnections between the various national markets that would allow this competition to thrive.

"The [European] Commission put the competition cart before the infrastructure horse," Helm says.

Perhaps in acknowledgment of this fact, the Commission’s February 2006 report into how the deregulation of the continent’s energy markets is progressing highlighted this lack of integration between the various national markets, along with market concentration, as the main impediments to competition.

The report noted there was no significant cross-border competition, with incumbents seemingly little interested in competing on their neighbours’ territory. In gas, new entrants aren’t able to secure transit capacity on key routes while in electricity cross-border trade is hampered by insufficient inter-connector capacity and long-term capacity reservations. One of the few exceptions to date has been Centrica Energy starting up operations in Germany this year trading under the name of Centrica Energie GmbH and focusing on power and gas marketing to public utilities and big companies.

"Buying into a market is the only sure-fire way to get started; every big utility knows that its competitors are going to be coming into its market so existing market share has nowhere to go but down," says Anton Krawchenko, an analyst with the consultancy Datamonitor,

"This creates a race – get into their market before they get into yours and keep your revenue and growth stable ahead of the inevitable loss of home market share by positioning yourself to grow in your competitors’ market," he says.

While competition helped bring in much needed investment to the sclerotic energy industries in the states of central and eastern Europe, it also opened up a vast new marketplace for Western utilities, who were sitting on huge stockpiles of cash that could be used to snap up smaller, poorly capitalised firms struggling to cope with the new environment of customer switching and different types of product tariffs.

The consolidation that ensued has been so swift and comprehensive that, some experts argue, the Commission was caught on the hop.

The Commission has arguably compounded this problem of concentration by continuing to approach M&A on a country-to-country basis, instead of looking at it on a regional basis. For example, the Competition Commission is waving through the deal between E.ON and Endesa on the grounds that the German company is not operating in the Spanish market so there are no competition issues. However, analysts say that Endesa could potentially become a very important competitor to E.ON in the future once these various markets have become interconnected.

"The [Commission] has ruled out competition of the future and have allowed a level of concentration that has caused a substantial reduction in the degree of competition that we can have," says Helm.

Indeed, the six largest utilities – Electrabel Group, Gaz de France (GdF), Enel, RWE, E.ON and Electricite de France (EdF) – now control 43.1% of Europe's market in terms of the amount of power and gas supply sold to end-users. If E.ON succeeds in buying Endesa, then the top six will have a 46.2% market share.

"In this light, you can see that the top six getting that extra 3.8% European market share by the end of next year, bringing the total to 50%, is actually a fairly conservative projection," says Krawchenko.

While the forces that are driving this consolidation in the industry are set to continue into this year, the conditions in which they operate might change if the Commission's recent actions and pronouncements are anything to go by.

Words of warning

In July 2005, the EU announced its intention to take legal action against Estonia, Ireland, Greece, Spain and Luxembourg for not having fully transcribed the energy directives, which form the basis of deregulation, into national law.

Thereafter, the focus of the EU's reform efforts has moved from the governmental level to a corporate level. In May, the Competition Directorate-General (DG) surprised everyone by launching raids on 20 energy company offices in five countries across the EU as part of an investigation into alleged anti-competitive practices.

On receiving yet another politically driven tie-up to create a national champion, this time between Suez and GdF, the Commission launched a far-reaching review that only ended in November when it approved the merger as long as the two companies made significant divestments. These asset sales include Distrigaz, a Suez-owned Belgian distributor of natural gas, and GdF's 25.5% stake in Société de Production d'Electricité, or SPE, Belgium's No. 2 electricity supplier behind Suez's Electrabel. In addition, the partners will also reduce their stake in Suez's Belgian gas distributor Fluxys to 45% from 57%, and GdF will sell its heating subsidiary Cofathec Coriance.

The approval of the merger followed a hard-hitting speech on October 30 by Competition Commissioner Neelie Kroes to the Conference on European Energy Strategy in Lisbon, in which she appeared to signal a move to end the vertical integration common among Europe's utilities by breaking them up if necessary – a radical step but one that can be imposed on a company or group of companies as a remedy to a breach of competition law.

"Kroes' proposed solutions are clearly preliminary and much work would need to be done to convince key players within the [Commission] and among EU governments before such proposals could be adopted, but they nevertheless give an indication that a stricter regulatory environment is a very real prospect for the near future," says Matthew Hall, an analyst with the consultancy Global Insights.

Even so, Kroes faces an uphill battle in her fight to push through any radical remedies.

Defence of status quo

Datamonitor's Krawchenko says that while there are powerful arguments for why networks should be independent, these integrated companies "have an arsenal of good arguments" to support industry consolidation and a continuation of the vertical integration model.

One favourite argument often trotted out is that consolidation gives European utilities the scale and power to deal effectively with the likes of Russia's gas monopoly Gazprom, which will never be unbundled, is hungry to buy up European energy assets and has a stranglehold on gas imports to Europe, contributing some 37% to Europe's gas needs.

"EdF has explicitly trumpeted 'security of supply' in its defence of the vertically integrated model," says Krawchenko.

This issue about keeping the lights on in Europe gets a fair hearing in many of Europe's capitals, vital political backing which is always likely to stymie any far-reaching reform steps emanating out of Brussels. "It may be [German Chancellor Angela] Merkel versus Kroes in the battle for network unbundling, and in that direct confrontation Merkel wins," reckons Krawchenko.

In addition, it's still unclear whether Kroes has the crucial backing of her colleagues, especially Energy Commissioner Andris Piebalgs, who is in charge of drafting the Commission's legislative proposals on the energy market due next year.

"European Commission president José Manuel Barroso, while continuing to express concerns over the state of the European energy market, has also stopped short of officially endorsing Kroes' point of view," says Global Insight's Hall.

It may be counterintuitive, but forced unbundling could also lead to more, not less, M&A. While making network infrastructure independent will probably force out from the sector private equity and infrastructure funds, which covet such assets as they provide a steady stream of revenue for leveraging the deal as much as possible, this process will at same time increase competitive pressures, which in turn boosts the driving forces behind M&A.

What might finally put the brakes on M&A would be for the Competition DG to begin looking at Europe as one market, rather than composed of individual markets, but analysts say this would require a paradigm shift in its thinking, something that is impossible to envision happening any time soon.

Time, of course, is not on Europe's side. By the time Kroes and the talking-shop that is the Commission actually gets measures designed to halt this M&A adopted and implemented, the industry shake-up and consolidation currently being played out will be nearing completion.

"The big M&A deals will be done and all the Eastern European bargains snatched up," says Krawchenko.

Source: Dealogic

Send comments to Nicholas Watson