The impact of COVID-19 is expected to be felt on the utility sector for quite some time. The uncertainty associated with the pandemic has roiled the financial markets in recent weeks and has altered the focus of many utilities. The likelihood of new large electric and natural gas utility mergers and acquisitions being announced in the near future has diminished significantly. In the water sector, the acceleration of small- to mid-sized municipal utility acquisitions is likely to continue. The changes in this highly fragmented sector have been driven by increasing capital investment needs and legislation that encourages consolidation.
Before COVID-19 entered the picture, there were already lackluster prospects for M&A activity in the energy utility sector due to prepandemic economic concerns, political uncertainty associated with the upcoming elections and enhanced scrutiny of deals in recent years by state regulators. These factors led to a pullback in 2019 M&A activity. Recent transactions have been small in scale relative to the deals that took place just a few years ago and mostly involved individual assets or subsidiaries rather than the large holding company deals.
Regulatory Research Associates, a group within S&P Global Market Intelligence, looks for utilities to experience a relatively modest negative financial impact from COVID-19 relative to more cyclical businesses, some of which have been meaningfully impacted by dramatic events of the past several weeks. In particular, given the essential nature of their products and economically regulated business models, utility revenues and net income may experience only modest declines in 2020. However, economic hardship will be a factor for some utility customers, and it will be a reasonable strategy for utilities to focus on this and other key operational matters such as maintaining existing infrastructure and ensuring the safety of their workforce. This is particularly important in an environment in which utilities may be requesting regulatory authority to recover COVID-19 related expenses or to defer them and establish regulatory assets. In short, regulators likely will not have much appetite for utilities pursuing M&A transactions in the current business climate.
Currently, there are only three large utility deals pending, with a combined market value of nearly $6 billion. El Paso Electric Co. reached an agreement in June 2019 to be acquired for $4.3 billion, including the company's net debt, by a special purpose entity, Sun Jupiter Holdings LLC, owned by IIF US Holdings 2 LP, an investment vehicle advised by J.P. Morgan Investment Management Inc. The Public Utility Commission of Texas approved the deal on Jan. 16, 2020, subject to the terms of a settlement reached in December 2019. The terms include significant rate credits and capital investment commitments, as well as ring-fencing provisions. The New Mexico Public Regulation Commission adopted a settlement on March 11, with similar provisions. The deal has received all other necessary regulatory approvals, including the Nuclear Regulatory Commission, the Federal Energy Regulatory Commission and the City of El Paso, but has not yet been executed. It is expected to close by June 1.
Eversource Energy announced a proposal to purchase Bay State Gas Co. for $1.1 billion on Feb. 26. The companies intend to engage in settlement negotiations with the Massachusetts attorney general.
The relatively small acquisition of Elkton Gas Co. by Chesapeake Utilities Corp. was announced on Dec. 9, 2019, and calls for Elkton to be purchased for $15 million. Currently, Elkton is owned by South Jersey Industries Inc., which acquired the company in 2018. A related filing was tendered to the Maryland Public Service Commission on Jan. 9, 2020. The PSC staff and the Office of People's Counsel recently said that additional commitments are necessary for the transaction to meet the statutory standards for approval of the transaction, namely that it is "consistent with the public interest, convenience and necessity, including benefits and no harm to consumers."
In a very small transaction proposed to Massachusetts regulators on Jan. 15, Algonquin Power & Utilities Corp. subsidiary Liberty Utilities (New England Natural Gas Company) Corp. is seeking approval to acquire Blackstone Gas Co. for $5.5 million.
In the water utility sector, two transactions of meaningful size are currently pending. On Nov. 20, 2019, American Water Works Co. Inc. announced an agreement to sell its New York American Water Co. operations for $608 million to Algonquin Power & Utilities subsidiary Liberty Utilities. In a joint petition filed on Feb. 28, 2020, the companies filed with the New York Public Service Commission for approval of the proposed sale. The transaction is expected to be completed in the second half of 2020.
On Sept. 17, 2019, Essential Utilities Inc. announced a $276.5 million acquisition of the wastewater assets of Delaware County Regional Water Quality Control Authority. This transaction, which marks the largest privatization of a public water or wastewater system in the state, is subject to Pennsylvania Public Utility Commission approval and is projected to close in 2020.
There are more than 20 additional water utility transactions pending that RRA is monitoring that are valued at a total of over $200 million.
Other potential transactions
Recently, activist investor Elliott Management Corporation and Evergy Inc. reached an agreement addressing the composition of Evergy's board of directors that, at the time, led some people in the industry to believe that a merger involving the company could occur in the near future. However, as COVID-19 became more pervasive, Elliott and Evergy agreed to modify certain deadlines in the utility's strategic review process. Evergy recently said that the deadline for a strategic review committee to submit a formal recommendation to the board is July 30, and the deadline for the board to vote on it is Aug. 17. If Evergy ultimately seeks to implement a "modified standalone plan," the deadline for such a plan to be submitted is Oct. 14.
A March 26 CreditSights report identified CenterPoint Energy Inc. as a potential acquisition target of Berkshire Hathaway Energy. Berkshire's recent debt financing and cancellation of its virtual analyst day prompted speculation that the company may be considering a potential utility acquisition, according to the credit research firm. The CenterPoint shares have been the hardest hit utility stock in 2020, having declined nearly 40% on the year, based on April 22 pricing.
While little recent meaningful action has occurred regarding financially troubled, state-owned South Carolina Public Service Authority, aka Santee Cooper, a low interest rate climate may present advantageous financing options for potential buyers of those utility operations. South Carolina began to explore sale options for the utility to help alleviate Santee Cooper's debt obligations following the failure of the V.C. Summer nuclear expansion. Various proposals have been submitted to acquire or possibly operate Santee Cooper.
One potential Santee Cooper buyer, and a rumored suitor of Evergy, NextEra Energy Inc., cited its strong financial position on its April 22 first-quarter earnings call as advantageously positioning the company to fight through negative impacts from COVID-19. From an operating profit perspective, management continued to project results at or near the top end of earnings per share expectation ranges in 2020, 2021 and 2022. In reply to a question regarding the company’s M&A stance in the current pandemic crisis, CEO Jim Robo, acknowledged uncertainty of financial markets, but generally remained supportive of possible acquisitions. Robo indicated that the company’s “strategic thinking around it remains unchanged and our approach to it remains unchanged, and that it ... has to be strategic, has to be accretive and has to be consistent with a very strong balance sheet.”
Utility M&A – a historical perspective
In 1985, prior to the completion of the deals announced that year, there were 90 primarily electric utilities, some stand-alone, some organized as holding companies that were part of RRA's coverage universe. Today, there are roughly 50 electric and gas utility holding companies in RRA's coverage universe, including smaller companies that were previously excluded from coverage but excluding non-U.S. holding companies that own U.S. utilities, such as Algonquin Power & Utilities, Emera Inc., Fortis Inc., Iberdrola SA and National Grid PLC.
In the early 1980s, there was not much in the way of major merger activity in the U.S. utility sector, as sales growth was robust and the path to earnings growth was largely through rate base additions, the electric utilities were finishing up large-scale generation construction projects and seeking rate recognition of those assets, and interest rates were rising. All in all, these characteristics were not favorable for M&A activity.
This began to change in the mid-1980s and early 1990s, as the last of the major generation, particularly nuclear, plant additions were being recognized in rates and demand growth began to slow down. In response, the utilities began to focus on cost reductions to provide earnings growth, and so, mergers generally involved utilities with contiguous service territories where economies of scale could be achieved.
In addition, companies began diversifying into related utility service businesses, while the 1992 Energy Policy Act furthered the country's public policy shift toward energy conservation and alternative resources, and large industrial customers began to lobby for the implementation of retail competition and electric industry restructuring to escape the interclass subsidies inherent in utility rate structures. These evolutionary changes in public policies caused utilities to look for alternatives to traditional avenues of growth.
Between the mid-1990s and the early part of the 2000s, with electric industry restructuring in full swing, utilities took one of two approaches. On one hand, strategic mergers focused on attaining some perceived critical mass of generation in order to achieve economies of scale and compete in unregulated markets and/or provide geographic diversification of generation assets. On the other hand, the idea was to achieve geographic diversification in delivery and regulated generation. During this period, the Public Utility Holding Company Act was repealed, opening the door for consolidation of utility holding companies with electric and gas operations, as well as interest in U.S. utility assets by foreign companies/investors and private equity investors.
As shown in the chart below, M&A activity for the electric and gas utilities declined significantly from 2008 to 2009, as utilities grappled with the effects of the economic recession; there were only four deals announced that year. Following the recession, the mantra became "back to basics," as companies that had made big bets on generation sought to diversify risk and stabilize cash flow by acquiring traditional utility delivery businesses. The presence of private investors and foreign ownership of utility assets continued to expand, utilities began getting into the midstream sector in the wake of the shale gas boom, the expansion of renewables mandates became a driving force behind proposed deals and interest in the water sector from traditionally energy-focused investors began to take hold, and vice versa.
As RRA indicated in a March 2019 presentation, there were 11 deals totaling nearly $75 billion completed during the preceding two-year period. RRA said the number of deals and their relative complexity and the implied premiums have caused utility commissions to take a more focused approach when reviewing proposed mergers in recent years. In addition, utility stakeholders and regulators have become more savvy in extracting beneficial commitments from deal participants in order to complete a transaction. This was, at the time, expected to contribute to a slow-down in merger activity in the sector.
The number of investor-owned water utilities has been reduced by half over the past few decades; the sector has only nine investor-owned companies. RRA follows eight out of these nine utilities and has identified 25 transactions valued over $250 million that have been completed over the past 20 years. Interest in water utility assets has come from a variety of places including domestic and international utility holding companies, private equity firms and infrastructure funds.
The water sector saw two material transactions in recent years. Most recently, SJW Group completed the acquisition of Connecticut Water Service Inc. on Oct. 9, 2019. The $1.1 billion transaction created the third-largest investor-owned water utility in the U.S, with a cross-country footprint and operations in four states. In December 2017, Eversource Energy completed the $1.7 billion acquisition of Aquarion Water Co. Inc., which has an overlapping New England service territory.
Consolidation of water, wastewater systems expected to continue
The water utility sector has been ripe for consolidation for decades. Over 50,000 water utility systems exist nationwide, and approximately 85% are municipally owned, while the remaining 15% are investor-owned or privately held. The municipal infrastructure consists of large urban systems with varying degrees of competence and economic health, an array of midsized and smaller cities and even smaller community systems in smaller towns in rural areas. Amid the fragmentation, high capital spending needs and financing pressures faced by many municipalities, the sector is overdue for significant consolidation.
Not all municipal governments are equipped, financially or operationally, to manage these challenges. Financially, municipal systems are challenged by limited available government funding, competing financial needs for other municipal services, such as fire and rescue, and the general unwillingness of elected officials to raise taxes. Operationally, smaller systems lack the expertise to keep up with increasingly stringent water quality standards. The presence of COVID-19 has further highlighted the technical expertise and benefits of economies of scale that the large investor-owned utilities posses, which could further encourage municipal owners to consider divesting water and wastewater systems.
Additionally, some states have enacted legislation that allows commissions to value the acquired systems based on market value rather than using an original cost basis determination. This valuation change is facilitating the consolidation of this fragmented sector. Virginia and West Virginia are the latest states to approve the use of "fair market value" legislation for water and wastewater utilities, which is now on the books in 13 states.
COVID-19 impacts commission operations, case time frames
RRA has drawn attention to the impact COVID-19 has had on the way utilities conduct business. In March, when COVID-19 led many businesses to shutter or impose unprecedented changes on their operations, RRA gave details about the initial measures taken by some commissions and utilities in light of the situation. RRA later gave an assessment of certain pending rate proceedings that had been delayed to that point and later released additional details, reflecting data available at the time.
In addition, RRA said the current state of affairs has the potential to impede the filing of some of these applications and pointed out that in the four weeks ended April 10, there were five rate proceedings initiated in the U.S., a stark contrast to the number of case filings that were submitted during the same period in each of the previous nine years. The data compiled from the recent period suggest that the logistical constraints associated with many organizations' transitions to remote operations were a possible factor that led to the sharp decline in filing activity.
Regulatory Research Associates is a group within S&P Global Market Intelligence.
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