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Clearing Up / Bearing Down

[September 1, 2017 / No. 1815]

In the Age of 'Scale,' What Happens to Those Who Don't Have It?

SUMMARY: The merger-and-acquisition wave in the IOU segment of the utility business is being driven by the quest for scale—the need to get bigger to reduce duplicative costs and achieve better pricing on capital. But that leaves the publics in a fix. What do they do to achieve the benefits of scale?

For many industries, the natural life cycle is toward consolidation, the reduction of many small competitors into a handful of very large entities gobbling most market share, with a few much smaller players feeding off the tiny scraps not worth the attention of the big outfits.

The auto industry consolidated from dozens of names to the Big Three, in the U.S. The same thing happened in the commercial aerospace industry, with the Seattle area being a major beneficiary. The history of retailing has been written by mergers and consolidations, whether it was in grocery stores, traditional department stores or discounters.

Merger-and-acquisition activity, and growth by consolidation, are driven by the theory of economies of scale—that bigger companies have competitive advantages in purchasing power, access to capital, marketing exposure, overhead that can be spread over a larger customer base, and reduction in duplication of operations.

It doesn't always work out so neatly. New entrants prove more nimble, or employ new technology and approaches more effectively. Bigness brings market power, but it also can lead to stagnation and complacency.

Nor does the model work in such neat theoretical terms for certain industries, like utilities. The combination of an industry structure of monopoly service territories at the retail level and extensive regulation on prices and services tends to blunt the forces that in other industries push consolidation.

Add to the mix the prevalence in the Northwest of public power, and the political forces behind it, and what you get (at least in this region) is an industry characterized by lots of small and medium-sized independent players.

But even utilities aren't immune to those natural forces. Other regions of the country have long been served by multistate giants like The Southern Co. and American Electric Power. M&A activity in the utility sector actually provoked a competition between buyers. Warren Buffett's Berkshire Hathaway, parent of PacifiCorp and other utility and energy companies, was thwarted in its bid to acquire Texas utility Oncor by Sempra Energy, which came in with a bigger number (you can't call it a bidding war because Buffett famously refuses to get involved in them).

Not surprisingly, the concept of scale figured in Berkshire Hathaway's interest. "We will gain access to additional operational and financial resources as we continue to position Oncor to support the evolving energy needs of our state," a release said.

That same theme made an appearance in Hydro One's bid for Spokane-based Avista. In fact that very word did. "This combination means greater scale, diversity and financial flexibility," the release announcing the deal said. "This strategic combination demonstrates the value of consolidation by bringing together twohighly complementary platforms to create one of North America's largest regulated utilities, meaningfully enhancing both shareholder and customer value. In addition, over time, non-headcount efficiencies will be realized through collaboration and sharing of best practices on IT, innovation and supply chain purchasing, all of which will further enhance cost savings."

It even figured in the sale of Puget Sound Energy to a consortium of investors, a deal announced in 2007: "Like many other utilities, Puget Sound Energy faces significant future capital requirements to meet the growing energy needs of our customers, while continuing to provide safe and reliable service to this dynamic region, ... The merger will provide us with $5 billion over the next five years, insulating us from volatility in the public equity markets."

A report from accounting firm Deloitte earlier this year identifies a driver for utility-sector consolidation. "Rising costs have become the norm for utility planners—and that's likely to persist as long as requirements and expectations from regulators, customers, and other stakeholders continue to mount," the report says. Those demands include replacing aging infrastructure, modernizing the grid, adding more renewables to generating portfolios and expanding natural-gas pipeline, storage and distribution capacity.

So smaller IOUs partner with each other, or with larger utility conglomerates, or with investment consortiums like the one backing PSE, all with the goal of wringing out costs in operations and borrowing.

And the publics like the municipals and PUDs will ... do what exactly?

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The demands on them to convert to renewables (and to add generation to accommodate growth), accommodate an increasingly complex and interconnected (not to mention expensive) grid, and replacing or rebuilding existing assets won't be any less on the publics than on the IOUs. But the opportunities to capitalize on scale will be.

That's a problem in the Northwest. Public power in the aggregate may be a big deal in the region overall (half of all customers in Washington, 17 percent in Oregon, according to numbers reported by the Energy Information Administration and the American Public Power Association) but not so much individually.

Of the 100 largest public-power utilities by electric customers served (2014 data), Puerto Rico is first with about 1.46 million; Los Angeles Department of Water & Power is next, at just over 1.4 million.

Seattle City Light? It ranks ninth, with almost a million fewer customers than L.A. Snohomish PUD is 13th, Clark Public Utilities comes in at 17th, Tacoma Power at 19th and then you drop down to Eugene Water & Electric Board in 34th.

In technical terms, those utilities aren't competing with others for customer market share; for their constituents local control is as crucial as the lower rates being a public promises. And it could turn out that big in the utility business means cumbersome, slow and bureaucratic.

But if scale does matter, then the publics have a challenge of finding some for themselves. Would they consider mergers? Weirder things have happened—the ports of Seattle and Tacoma, public entities in separate counties, combined most of their maritime operations into one jointly owned and managed operation.

There may be little precedent for a similar arrangement in the utility business, but such are the mounting pressures on utilities that some small or mid-sized public may feel compelled to create one. [Bill Virgin]

Bearing Down is excerpted from Energy NewsData's Clearing Up publication. If you aren't a current subscriber, see for yourself how NewsData reporters put events in an accurate and meaningful context -- request a sample of Clearing Up.

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