Europe to Be Major Investment Focus of the Near Future

Chris Nichols

uropean energy utilities find themselves at E the new frontier of international energy investment. Europe looks set to be the new hot zone for years to come. This is an arena in which we can expect to see almost everything change within a decade: structure, markets, ownership, and strategies. The electric sector is already witnessing unparalleled levels of asset churn and strategic repositioning. The gas sector is likely shaping up to follow. The two markets are deeply intertwined. Change in one influences the shape of change in the other.

Europe looks set to be the new hot zone for y e a r s t

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One challenge for utility strategists and investors is to understand the forces at work and take position for the coming landscape.

A Snapshot of Trends For years, nothing happened. In a world of

transformation, European utilities were-at home at least-both untroubled and benign. Mean- while, change engulfed the electric and gas utility industry of the United States, United Kingdom, and Australia. Times have changed.

Recent PricewaterhouseCoopers research has shown clearly that Europe now leads the race as the destination of choice for electric sector investment. In addition, the nature of the deals was in transition. Smaller deals came to the forefront of investment action. Though total cross-border deal volume fell, the number of transactions reached a record high: 27 dis- closed-value deals (amounting to $24 billion) and 18 deals without disclosed value.

The gas industry does not yet match this level of activity. But there is clear evidence of early positioning. A number of defensive and posi- tional deals have been announced. Many Euro- pean gas deals are regional alliances to protect their home space: Gas Natural’s link to Endesa and Gaz de France (GdF) to TotalFina Elf each have aspects that may be seen in this light.

We are also seeing more subtle forms of defensive positioning. Where European gas third- party access ( P A ) regimes are becoming avail- able, some are regarded as chilly towards the needs of traders and shippers. The early days of U.S. gas post 636 saw similar TPA terms. We see the same today in the U.S. electric sector, where electric utilities and regional transmission organi- zations (RTOs) are involved in a steady stream of Federal Energy Regulatory Commission (FERC) investigations into the terms of electric TPA brought to the regulator by third parties.

We also see evidence of deals focused on European growth, and the first signs of strategic positions being staked out in the market. The Centrica-Essent link is the first cross-border

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Chris Nichols is director, international business development, Henwood Energy Services Inc., a busi- ness solutions provider for energy investors glo- bally. He is an advisor in energy restructuring and investment and has advised investors and utilities in over 30 countries in Europe, Norfh America, Asia- Pacific, Australasia, and Africa. This article was written with contributions from Philippe Carpentier and Ali Tahghghi of EJC Energy concerning gas developments in Europe. High-value input was also received from Jim Harrington and Rosemary Boulton of Houston Energy Group in respect to investor strategy. The author wishes to express his gratitude for these contributions, but remains solely regpon- sible for any errors.

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alliance focused on wholesale and downstream gas markets in Europe. Ruhrgas has marked out a move towards a competitive retail proposition with Ruhrgas Direkt. GdF has started its up- stream integration with the aim to produce 15 percent of its own gas needs by 2005.

In preparation for a fundamental restructur- ing, smart players are starting to develop posi- tions that capture part of the new value chain. Players are integrating upstream, downstream, or sometimes both. Some corporations are riding several horses. This is also normal in the early days of liberalization. In an uncertain environ- ment companies do not know which link in the supply chain will provide the highest returns: one solution is to be temporarily present in all.

Players inside Europe know that they face new challenges. Both within Europe and the boardrooms of the United States, investors are awake to the new opportunities. In the heart of the Old World there is a New World to win.

Forces and Outcomes Investors, in their strategic analysis, are

seeking to understand the implications for the European gas market of the liberalization plans of the Directive and the likely course of imple- mentation in individual nations. Investors also

face the need to interpret the changing nature of a New Europe itself and are trying to keep a weather eye on the implications of the different shapes New Europe may take.

European Gas Market The European gas market is significant in

size and has scope to grow significant trading activity. The present strategic maneuvering is a direct response to the liberalization policies of the European Gas Directive and all it may bring as this market comes into play.

The gas liberalization, in common with its electric counterpart, envisages a European the- ater that is open at the wholesale level. In some cases the residential sector may be put into play. Throughout the market, “unbundled” financial information is to be laid bare to facilitate regu- lation and TPA terms. As with electricity, the policy allows national flexibility. Individual European states continue to move at different paces, oftentimes with differences of underly- ing intent. However, the overall push for market opening is clear (see Exhibit 1).

The New Europe Nothing much in the future of Europe is

clear. Despite progress on integration in re- cent years, there remain barely reconcilable differences in attitude within the European Union (EU) member states on the form, de- gree, and pace of future economic and policy integration.

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At the same time that the core EU lacks clarity, a wider population seeks membership. There are plans to expand the EU from its current level to 30 states. From Poland to Turkey, nations line up to join the party, though no one is sure what the party entails.

Skepticism is emerging in some member nations about the benefits of current and further integration. Others point to deepening the link- ages. Some propose Euro-federalism as a rem- edy. Most recognize that enlargement without streamlining the labyrinthine decision-making structures of the EU will be a disaster.

A two-speed Europe is possible. Some may subscribe to inner-core federalism, others will remain aloof.

Enlargement will add economic and policy complexity. The potential entrants range from the nearly ready to the far fringe. There is not a chance that EU liberalized energy policy can be extended at once across all would-be EU states.

Still more fundamental issues about eco- nomic stability and basic structural issues arise in respect to many aspirant member economies, particularly as you look to the east. Any enlarge- ment of Europe is likely to be incremental and will involve significant transitional costs.

However, as enlargement comes, there is another vast market opening to EU players and inward investors alike. The question is what will be the timing and nature of the opportunity? Additionally, how can companies be best posi- tioned to take advantage of the opportunities that do emerge?

We suspect that sharp analysis, understand- ing, and patience-coupled to vision to take up positional opportunities-will be the key. Any investor into the EU will need to assess the scenarios that could unfold in the economic and policy future of the EU. As Yogi Berra said, “prediction is hard, especially when it’s about the future.” All we can do is analyze and understand how the unfolding of hybrid sce- nario elements will impact the potential for and performance of energy investments throughout Europe.

Whatever the uncertainties, opportunities do exist.

Potential Outcomes Investors and incumbents alike are focusing

today on the range of opportunities that the unfolding of European gas and power liberal- ized markets will yield.

The range of openings will include the following:

Consolidation and cross-borderasset churn: There is significant scope for consolidation across Europe, in transmission, and more so in local distribution. Some markets have yet to commence any degree of consolidation. U.S., Australian, and United Kingdom elec- tric and gas experience shows that liberal- ized competition can yield consolidation, though in some European states commer- cial pressures may be resisted for some time. Additionally today’s deals fuel tomorrow’s portfolio refinements. As investors shift po- sition in an evolving market, churn is to be expected. Deals are not “right” or “wrong” forever. We can expect to see continuing, even accelerating churn, as investors seek to balance their portfolio and create a sustain- able position. Entergy’s shifts in asset base overseas, and Enron’s entry into and exit from the electric utility sector are ready evidence of the likelihood of this type of asset churn. Value-chain redesign: Many of the opportu- nities relate to value-chain adjustment- openings for corporations to move up or down the value chain by forward or back- ward integration. Already Shell, Exxon, TotalFina Elf, and Statoil own equity inter- ests in downstream activity across several EU countries. Ruhrgas and GdF have moved upstream to secure production. Horizontal integration also offers openings. Convergence and power generation: There is the opportunity today to stake a multiutility position in Europe, and several players have started down this track. Some existing EU mergers are, like their US. counterparts, aimed at creating combined gas and electric offerings. Essent and NUON-ENW are multiutility operations. Several multiutility players have already hung out their shingle in the United Kingdom. Gas-to-powerprojects: As the EU power mar- ket liberalizes, opportunities for such projects will increase. Many EU countries have low levels of gas-fired power plant. Open mar- kets will tend to increase combined-cycle gas turbine (CCGT) investment by new entrants. There would appear to be early prospects in Spain and Italy, with later openings in Bel- gium, Germany, and (possibly) France.

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Transportation: International investment op- portunities in European transportation may be slow to develop. Early efforts by players such as TransCanada International proved disappointing. There is a clear local mo- nopoly situation in most EU countries, and barriers to entry by outsiders may be high in terms of policy constraints. Nonetheless, liberalization does offer the potential for additional pipeline capacity to be added by new entrants and for existing assets to be acquired. As gas transportation becomes a more fully commercial activity, and, importantly, as other aspects of the gas value chain open for competition, opportu- nities to invest in innovative transportation solutions will be likely to grow. Storage: A significant proportion (43 percent) of European gas usage is for residential and commercial purposes. This load is volatile and heavily weather dependent. This situa- tion leads to a peaky load curve. It is likely that opportunities for gas storage invest- ments will increase in Europe, particularly if Europe moves into a supply deficit position over the next decade or two and EU nations come to rely on long-distance supplies with lower swing production facilities. Storage opportunities require investors to make ac- curate market and timing assessments. These opportunities will depend on the develop- ment of trading in the gas market, because at the moment there may be too little price differentiation between peak and nonpeak gas to make storage projects economic. Trading: Gas trading is at an early stage of development in Europe. Only the United Kingdom has both a physical and financial market. Nonetheless, physical trading is opening up in several EU centers, particu- larly Holland, Germany, and Belgium. Fi- nancial instruments are far less developed in Continental Europe, and while this begin- ning would appear to offer an opening for knowledgeable investors, timing is impor- tant and the development of the financial market will likely have to await the appear- ance of more liquid physical trading.

Tomorrow’s Transformations: New Deals for a New Europe

When looking at investment to date into the liberalizing gas sector, it is possible to separate investments into four “stages” of activity:

Investigative-where the investment may or may not meet normal commercial criteria, but supports organizational learning about a new market. Positionak“a strategic toe in the water,” usually in the form of a small acquisition or a joint venture (JV) but can be more signifi- cant depending on the nature of the investor and the market. Traditionaka commercial-style investment, expected to produce a satisfactory return. Transformational-a bold value chain re- structuring that spans regions, where the investment into a territory can only be explained as part of the broader portfolio of holdings.

The majority of current utility investments in Europe fall into the investigative and posi- tional types.

Most deals within the United States (particu- larly like-to-like utility mergers) are traditional in nature.

However, we are seeing several major play- ers looking towards significant transformational deals in the coming five years or so in both the North American and European theaters.

It is interesting to plot some of the major strategic transactions of recent months to assess where they fit into this typology (see Exhibit 2).

There is nothing wrong with positional or exploratory deals. Exploration is a source of growth. Position lays the foundation. Tradi- tional deals are where ordinary value gets extracted, efficiently and to the satisfaction of the stockholder.

However, few deals in these categories reshape the industry, though some border on it. In terms of Exhibit 2 we would highlight the following for mention:

The EnrodAOLABM linkup clearly has the potential to reshape energy retail in the United States now, and Europe tomorrow and beyond. The extent to which this suc- ceeds will depend on the skills of the team, regulatory and policy impediment, and the willingness of residential customers to switch. United Kingdom experience suggests that the latter will happen if the offer is right and the market permits. Montana Power (MPS) was a traditional U.S. integrated electric utility, with limited gas interests, until it redesigned itself as a tele-

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communications play. In one of the very first switches out of utility provision, MPS sold first its generation, then proposed to sell its wires, to focus on its growing na- tional telecommunications interests. Will this be a viable strategy for others? 24/7: a JV of Texas Utilities (TXU) (Energy Group, United Kingdom) and EdF (London Electricity, United Kingdom) is a new ap- proach to managing the network of two utilities. Creating a new service company structure, the JV parties intend initially to exploit economies of scale in network opera- tion without the need to merge their assets. Later they plan to acquire other networks or sell their management services to others.

Each of these deals is transformational to some extent. However, there are other deals that will come to occupy the upper-right-hand space in Exhibit 2.

Tomorrow’s headline deals will be quite different from the majority seen to date. They will be about strategic transformation. Tomorrow’s deals will redesign the value chain in a different way, as investors form distinct strategic groups. The Enron/IBM/AOL deal ex- cepted, today’s deals are not yet fully in this category.

The future deal typology anticipates greater specialization in utility sector investment and strategy, with the emergence of at least five distinct strategic groups. The groups will include:

GlobalRelationsbipEnqy Traden(GREA?S): GREATS will be asset-backed integration plays that allow incoming investors to access new markets byJV, or alliance arrangements that offer a degree of reciprocal “home market or “third market” access to their JV counter party. A US. major might, for ex- ample, offer use of its trading facilities and knowledge in the United States to a German player, in return for joint marketing around assets the U.S. player has developed or acquired in the German market. The GREAT structure also allows for further parties to join the alliance to allow eased access to further target markets. The aim of the GREAT structure is to reduce market entry costs (and the risk of failure) by specifi- cally crafted marketing and trading coopera- tion around the operation of specific assets. As with all JV structures, careful partner selection and close alignment of objectives will be critical determinants of success. Channel Maximizing Retail Players (CHAMPS): CHAMPS are genuine, multiutility

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retail operators that specialize in creating competitive customer offerings across sev- eral product and service lines. In Europe it is also likely that these combinations will seek to operate across borders, rather than solely within one country, a n d p or alliance structures may be appropriate vehicles to achieve this market entry. Generation Innovators (GENS)): GENIS are smart generators that embrace a techno- logical or portfolio advantage. In Europe, opportunities for GENIS will emerge in three ways. First, they will emerge from the liberalization of gas and power markets directly, because Europe has (like many noncompetitive markets) seen little of the innovative entry by CCGT merchant facili- ties seen in the United States or United Kingdom. Second, as network pricing in gas and electric matures, openings will emerge for embedded and distributed fa- cilities to exploit locational opportunities. Third, as network players in gas and elec- tricity become more commercial, they will seek to push the envelope of network operations, by seeking to exploit embed- ded technologies and mechanisms for providing reserve. This will also create openings for JVs between network owners and GENIS. Horizontally Integrated Transcos (HITS); HITS link up gas and power transportation facilities. There is probably more value in energy transportation than many investors realize. Combining gas and electric systems allows for optimization of network utiliza- tion through innovative pricing. It also of- fers the opportunity for superior network planning and the siting of facilities. In Eu- rope, the main barriers to HITS will be twofold. Regulatory obstacles may make such asset concentration either difficult or unattractive (as HITS may attract special regulatory scrutiny and be barred from ex- ploiting their commercial advantages). The creation of HITS will also require electric and gas parties to share a vision and agree on relative asset values and share of the deal. Both of these factors have so far hindered progress towards HITS in the US. market, where there have been attempts to develop such vehicles. Portfolio Networklnnovators (POMS): PONIS are smart distribution system operators, span-

ning gas, electric, and other network mo- nopoly services. They will radically outsource their operations, with the core being small and focused on value creation. PONIS will also push the envelope of network opera- tions by linkages with GENIS, and with technology providers, to extract maximum value from their network assets. Elements of the PONI strategy are already evident in the TXU/EdF joint venture in the United King- dom, in ABB’s acquisition of a United King- dom electric utility’s engineering services facilities, and in Siemen’s recent acquisition of TXU Europe’s metering operations. The radical outsource element of a PONI can be seen in Envestra (Australia), which manages a portfolio of networks with a minimal management team and a range of outsource operational service providers.

No doubt, over time, further innovative structures will emerge as investors identify new ways to create sustainable value in the unfold- ing European competitive market.

Conclusions and Investor Success Characteristics

There seems to be little doubt that over the coming decade, Europe will be a major focus of energy investor attention. The direction of liberalization is set, in both gas and electricity. The broader reform of the EU and its enlarge- ment to the east open a further frontier of investment opportunity.

Utilities in gas and electric are already positioning in response. Over time, it seems likely that the deals will change in nature. Today’s deals are early steps in a process that will result in the transformation of the gas and power sectors with the two sectors becoming increasingly interwoven through combined as- set ownership and trading and retail offerings.

Tomorrow’s deals will be transformational in character, with investors developing innova- tive alliances and approaches to implement their focused positioning for sustained value creation. Europe will both lead and reflect transaction structures that will come into use around the world.

In the heart of the Old World, investors will win new opportunities for growth. As the suc- cessful pursue the opportunities, they will in turn reinvent the marketplace and reshape the energy sector.

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