Mergers and acquisitions: special dangers and opportunities.

• Author: Collier, Steve

Unprecedented ownership restructuring is taking place in the electric utility industry. Mergers and acquisitions, two forms of restructuring, represent both strategic opportunities and threats for electric utilities. Our author discusses the reasons ownership changes hands, valuing companies, special cooperative attributes and circumstances, dangers for cooperatives, and most importantly, opportunities for cooperatives as it relates to increasing competition and the threat of involuntary ownership changes. This article stems from a presentation Mr. Collier made to NRECA's Advanced Management Program, Mergers and Acquisitions: Who's Going to Own Your System, in September 1993. INTRODUCTION

Profound changes in the electric utility industry are altering the factors which drive the expectations of both customers and owners. Increasing competition for customers causes pressure to lower price and increase service. This tends to reduce revenues and raise costs. Greater competition allows for less variation in prices and service quality among companies in the industry. Competition for resources (e.g., capital, land, fuel, environmental impact, etc.) complicates corporate planning and may further escalate costs. Regulatory and economic uncertainties further complicate planning and operations. These all have unavoidable effects on profitability and return on owners' investment. Some utilities are well situated for the new conditions while others are not. New competitors challenge even the most successful established companies. When these circumstances are coupled with ubiquitous and fierce competition for capital and return on investment in a market-driven national economy, changes in corporate structure, even ownership, are inevitable. While these phenomena are common to private enterprise throughout the United States economy, they are relatively new to the electric utility industry. Utilities had for a century operated as regulated monopolies serving a relatively inflexible demand and receiving revenues certain to exceed costs. Various events in the 1970s and 1980s and the ensuing actions of customers, owners, regulators and lenders have shifted, even destroyed that long-standing paradigm. Competition for retail customers, resources and even ownership of assets is now the prevailing factor in the industry.

Now, unprecedented ownership restructuring is increasingly commonplace among electric utilities. The changes in ownership range from distressed sellouts of companies unable to cope with new and ever changing paradigms to hostile takeovers of viable corporations. Deregulation and the resulting diversification and divestitures multiply the variations. Mergers and acquisitions represent both strategic opportunities and threats for electric utilities. The special attributes and circumstances of electric distribution cooperatives cause the opportunities and threats to be all the more important. Special care is necessary for cooperatives to withstand the dangers and, more importantly, reap the strategic advantages of mergers and acquisitions. THE TRADITIONAL PARADIGM

The late 1870s marked the advent of the electric utility company. An industry that began with largely novelty arc-lighting service in downtown urban areas and industrial centers expanded rapidly with a proliferation of technologies for generation, distribution and utilization of electricity. By the turn of the century, there were more than three thousand electric utility companies providing service throughout the United States.

The introduction of electricity in the United States had a revolutionary beneficial effect on the quality of life and productivity of business, leading to an almost insatiable demand lot increased generation and utilization. The industry grew in size by a factor of more than two hundred times from about three million kilowatts of installed capacity in 1900 to more than 600 million kilowatts by 1970. Technological advances combined with economies of scale led to declining real prices. A kilowatt-hour which cost about 25 cents in 1900 (i.e., really about $30 in 1970 dollars) declined in real dollars by a factor of about a thousand times to about 3 cents by 1970.

Under the leadership of Samuel Insull and others, the industry grew mostly through investor-owned utility companies. Mergers and acquisitions marked the early 1900s as holding companies flourished, only to crumble in the stock market crisis of 1929. The industry structure was based upon an implicit social contract which enabled utility companies to remain monopolies in exchange for accepting price regulation and undertaking an obligation to serve. The price regulation, with largely inflexible demand for the monopoly's product, actually represented a sort of cost-plus guarantee. The obligation to serve was really more of an opportunity to serve everyone at a profit. This made for great corporate financial performances and very stable corporate structures. Utilities largely existed as islands, serving their own customers with their own assets, free from all but fringe competition. This was a stable and prosperous industry paradigm, marked by happy customers and satisfied investors. There was little reason for changes in ownership or structure, and mergers and acquisitions were rare. All this was to change drastically after the 1970s. THE END OF STABILITY

A series of events beginning in the late 1960s led to the conditions now favoring merger and acquisition activity in the electric utility industry. The great Northeast blackout of 1965 led to the formation of regional reliability councils with new transmission interconnections and increased generation reserve margins. This meant for the first time in decades upward pressure on costs and thus prices. Perhaps more importantly, new opportunities were created for power purchase and sale transactions between and among newly connected islands. The OPEC oil embargoes of 1973 and 1979 caused drastic increases in energy prices, and specifically in electricity prices. These increases were exacerbated for electric utilities by large capital investments in more expensive generation using coal or nuclear fuel in conjunction with inflation and correspondingly high interest costs. Customers reacted immediately, with reduced consumption, obvious dissatisfaction and greater participation in the regulatory process. The sharply reduced consumption persevered, and compounded utilities' pricing problems with lower growth or even decline in sales and revenues in the face of increasing costs and complexities.

The public policy crises accompanying the Viet Nam War and Watergate revealed new values and concerns of voters, consumers and investors. National energy policy became an important focus, with environmental and efficiency concerns being strong influences. The Public Utility Regulatory Policies Act of 1978 ("PURPA") mandated new approaches to the production and pricing of electric power. Even more importantly, PURPA encouraged competition in the production of electric power, breaking the long-standing utility company monopoly over the generation and transmission of electricity. Two outgrowths of these events substantially eroded the cost-plus pricing part of the traditional paradigm. First, regulatory prudence reviews, initiated to slow the rise in electricity prices, disallowed costs. Second, opportunity transactions between and among utilities and non- utility producers proliferated with pricing set by market forces, not by the cost-plus guarantee. Even sales to large retail customers began to be affected by market type forces as prices and service arrangements were dictated by...