As a result of liberalisation, the European energy markets have undergone fundamental change. The whole framework of the energy industry has changed significantly, and will continue to do so, as a result of deregulation. Due to EU directives and the resulting national energy law amendments, new market rules – such as regulation of network access, calculation of grid fees – have been implemented for the power and gas market.
The European Commission’s (EC) aim is to develop a common European market for energy where customers benefit from competition driven improvements to service and quality as well as decreasing prices. This goal was the basis for deregulation of monopolies and the opening up of markets in EU member countries.
However, different countries took different approaches to deregulation. In reality, protectionist and prohibitive behaviour continued, and utilities have maintained their expansion strategies without experiencing substantial threats in their home markets. These strategies involved seeking vertical and horizontal integration along the value chain and acquiring shareholdings in foreign companies. The strategy was especially successful in EU countries that were ahead of the game and who opened their markets early (such as the UK). Subsequently, countries then outside the EU, such as Hungary, the Czech Republic and Romania, became increasingly attractive as they became EU member candidates due to their strong economic growth rates and an increasing potential for energy consumption. Utilities embracing this strategy include Germany’s E.ON and RWE, France’s EDF and Central Europe’s OMV with shareholdings in Hungary, the Czech Republic and Romania.
The next consolidation phase will see a wave of mergers and acquisitions in the EU. The industry will see the market entry of companies, like Gazprom, pursuing a strategy of a forward integration along the value chain. This evolution has resulted in the European energy market being dominated by a dozen key players. Forecasts predict a possible oligopoly of 5 or 6 companies spanning the entire European marketplace. The question therefore is, has the European energy industry has entered a final consolidation phase or if this is just another stage in a continuing cycle?
The sections that follow provide an overview of the efforts the EU has gone through to create a common European energy market and the associated regulation measures that were defined by the Commission earlier this year. It also evaluates the resulting strategies European energy companies have undertaken and the measures utilities need to take in order to maintain their competitiveness. We also provide our opinion on possible scenarios of the development for the European energy industry regarding the effects of regulation, market structures and competition.
Convergence of European Markets
The main objective of the EU’s energy market liberalisation was to enhance competition in gas and electricity markets by creating a common European energy marketplace. The opening up of markets significantly changed how they functioned, providing new opportunities, new products and services, and (initially) lower energy prices. However, while progress has been made, the objectives of liberalisation have not yet been fully realised. Problems include: the continued existence of barriers to free competition, significant rises in gas and electricity wholesale prices (which cannot be explained by higher primary fuel costs or environmental obligations) and persistent complaints about entry barriers and discrimination. These issues have led the Commission to define measures to realise the full potential of the internal gas and electricity market by January 2009.
A recently published strategy paper on the future of the European energy market defined the following measures:
- Definition of new unbundling regulations: To avoid discrimination and market foreclosure, the paper discusses the unbundling of network ownership and the independent system operator approach. The Commission has a clear preference for ownership unbundling because this is the most effective way to ensure competition (because network operators are not influenced by supply and generation interests). It also avoids complex regulatory and administrative burdens that would be required for the independent system operator approach.
- Establishment of European-wide market regulation: To close the existing gaps between the national regulatory environments, a new single body at EU level is planned. It would provide functioning European wide regulation and facilitate crossborder trade.
- Enforcement of strict competition: The EU will make full use of existing regulations to pursue infringements of competition law and combat market domination. Possible sanctions are energy release programs (already successfully applied in Austria, France, Spain and Germany), the prohibition of long-term gas supply contracts and of long-term power purchase agreements. Unlike in the past, the EU will define strict requirements and may claim divestures, asset and contract swaps for the approval of mergers and acquisitions (M&A) in the future.
- Enhancement of investments: Several actions are proposed to speed up investments in networks (particularly at borders between countries) and power generation plants to ensure security of supply and to create an integrated European market. Further details on these actions are expected to be published in the near future.
The efforts to create a common European energy market, and associated actions taken by the EU, will determine, in conjunction with other market trends, the strategies of the major European utilities. These must be implemented to cope with the increasing pressures of regulation, competition and the expectations of capital markets and investors. Companies will evaluate their business units based on their realised return in relation to the capital employed. The achieveable return and the value enhancement of capital employed will determine strategy and decisions about alternative investment strategies. Utilities undertaking this evaluation will examine each business unit under portfolio-based value creation indicators.
To create value, it is necessary to realise a capital return above capital cost not only on the level of the entire company, but also for all steps of the value chain.
The Strategies of European Energy Companies
The market requirements highlighted above imply strategies that focus on cost reduction, securing buying power for resources (gas, coal etc.), safeguarding the company’s financial strength and the defence of hostile acquisitions. Further growth from M&A will also bean integral element. In particular, those companies whose efforts to take over competitors have failed in the recent past (such as Gazprom and Gas Natural) will further increase their efforts in identifying suitable targets.
The waves of consolidation of the past and current national and European anti-trust laws create a unique strategic position for utilities. A number of different company types and strategies can be identified:
- European champions: Champions like E.ON, EdF and RWE have subsidiaries in regions outside their national markets. They will strive to further strengthen their position in Europe and realise growth in markets they have not yet penetrated. The ambition of E.ON to take over Endesa is one such example.
- National champions: Champions, such as ENEL, Dong, Essent and Nuon, have not had the opportunity to grow by M&A in their national markets due to antitrust restrictions or their particular market structures. These champions will use their financial strength for cross-border acquisitions to avoid being acquired by competitors. Dong and ENEL, for example, have already started acquiring the shareholdings of competitors in foreign markets.
- Oil and gas producers: Oil and gas producers, such as Gazprom, are expected to pursue forward integration along the value chain to gain access to end customers. Potential targets include regional and municipal utilities. For example, RWE is a potential target for Gazprom. Furthermore, it is expected that Gazprom will bid for a shareholding of a municipal utility in Germany (Stadtwerke Leipzig).
- Specialists with sector focus: Single focus organisations, such as Gas Natural and Centrica, are expected to gain access to other energy sectors through the M&A of national or international competitors. Although the latest efforts of Gas Natural to acquire Endesa failed, further attempts to integrate gas or electricity sectors are likely.
Depending on the success of these strategies and the development of European energy regulation, a diverse range of future market structures could emerge.
Future Scenarios for the European Energy Market
Given the developments in the European energy markets that PA Consulting has observed over the last two years, there are at least three potential scenarios for the future market structure:
• European Power and Gas Oligopoly
• Increased Market Fragmentation
• Regulated Restructuring
Scenario 1: European Power & Gas Oligopoly
Current M&A activity in the market points to the creation of a few very large pan-European and vertically integrated power and gas utilities. They would cover all parts of the value chain, from upstream to downstream sales, and possibly including grid operations. Large players, such as EDF, E.ON, RWEand ENI will increase their market sharein Europe to fulfil the expectations of their shareholders. Operationally, they will aim to realise economies of scale within their organisations and arbitrational effects across different markets.
In most European countries, as the national competition authority prevents further national mergers or takeovers, the large players can only grow outside their home countries to demonstrate to shareholders that they are creating value. Organisations that are unable to grow in this manner risk lower share price growth and hostile acquisitions as their market capitalisation decreases. This market development will lead to a strong dominance of the large players that could then influence the most important commercial mechanisms in the market, such as wholesale or retail prices.
To apply pressure against this oligopoly, local and regional utilities will start to cooperate more closely and, ultimately, have to merge. The newly emerging national retail offerings both for power and gas, such as in Germany, will push the smaller players into a position where regional collaboration is one of the main measures to counter the market power of the large players.
At completion, this scenario will see a market with a handful of pan-European players and, within each national market, a handful of regional utilities merged out of the municipal suppliers.
In simple terms, this market development could be described as the behemoths against the locals. The consequence for the end consumer of such a concentrated market will most likely be limited competition and therefore, limited potential for decreased costs. The suppliers, however, will be able to relieve the pressure on the retail margin as a consequence of concentration.
In addition, this scenario provides an opportunity for large non-power oligopolists from the oil and gas upstream market (such as Gazprom) to create a downstream arm in continental Europe. Reasons for this include:
• Creation of a physically more balanced portfolio between exploration and supply.
• Potential to participate in the margins that lie along the energy value chain.
The most appropriate targets for this action are municipal utilities because many municipalities are willing to sell at least minority stakes due to their difficult financial situation. Potential buyers include other municipal utilities (pending an upturn in their financial situation), financial investors (pending rate of return) or upstream oil and gas companies (pending barriers to new market entry). Upstream organisations may invest at a premium price to add a downstream operation to their portfolio. The consequences would be an even fiercer concentration process as the market would then be even more dominated by large, pan-European players. The small utilities would then be forced into a niche existence, serving economically underdeveloped areas and customers.
Scenario 2: Increased Market Fragmentation
At the beginning of market liberalisation in Europe in the middle to late 1990s, it was commonly expected that the value chain would split into its segments and specialists or niche players would emerge. However, in most markets this development has not occurred because a new equilibrium has been found that does not require a separation of parts of the value chain. Due to the recent increased pressure from large competitors and regulators (especially in Germany) utilities have begun to spin-off, or prepare to spin-off, customer service companies, metering companies, billing companies and grid service companies, among others. There are several reasons for this approach:
• Reducing employment costs.
• Reducing lagging areas in the value chain.
• Exploiting potential market opportunities outside the home territory.
As existing oligopolistic market structures prevail or strengthen, spin-offs are seen as one mode of survival for the smaller players. For utilities that are already operating in various areas of the value chain (i.e. profit centres with market prices as transfer prices), the spin-offs are seen as an opportunity to sell off parts of the value chain that do not meet the rate of return objectives.
The newly formed legal entities can then easily merge or cooperate with similar specialists, growing market share and realising economies of scale. In simple terms, this market development can be called increased fragmentation. This scenario will lead to a market structure that consists of vertically integrated players offering operations along the entire energy value chain and an increasingly concentrated group of value chain specialists. The smaller suppliers will likely cooperate with the specialists to realise cost benefits and will take their chance in the supply market, looking to survive against the pan-national players.
Scenario 3: Regulated Restructuring
Recently, the European Commission, competition authorities and several national governments began to consider and discuss further measures to increase competition in Europe’s energy markets. Given that an oligopolistic structure has already emerged, and that in most markets competition is low, the idea is to forcefully restructure the large players that have formed since liberalisation began. Ownership unbundling of the grid or the forced sale of generation capacities are potential methods to reduce these oligopolies and fragment the market again. Despite the legal obstacles facing such a forced market restructuring, it is questionable whether it would lead to a stronger competitive environment in the long-term. In other markets, such a forceful fragmentation does not prevail for long because the necessity for a decreased cost base leads to mergers and ultimately, larger players again. The sheer number of players or their ownership structure is not a guarantee of competition.
The German market is an excellent example of this. Local municipalities are merging to increase market power and realise synergies. The spin-off of billing, metering and service companies that are beginning to merge or cooperate with other such players has also been observed. In addition, investors are bidding successfully on municipal stakes and municipalities that are willing to sell their shares. The Endesa deal, the potential merger of Nuon and Essent (now called off), or GDF and Suez (now imminent), also show that the future European energy market will be structured into pan- European, vertically integrated oligopolists, with merged local utilitiesfor supply, and merged service specialists with a lower cost base to collaborate with the suppliers. The driving force behind these structural changes will be realising value growth and decreasing the cost base in a market where margins, at least at the retail end, are eroded. Ultimately, these developments could lead to a market structure that is more comparable with the oil industry. This could be the end game of the power and gas market.
However, it is also possible that this end game is actually a new cycle in market structure development. Recent changes within various regulatory authorities in Europe indicate that such regimes could be much more stringent in order to force competition into the European market. When a true oligopolistic market structure has emerged, consumer pressure on politicians could increase as liberalisation has not realised its initial objectives. A European regulatory authority could then attempt to forcibly restructure the market to improve competition.
This scenario is then similar to the mid-1990s. The situation, however, will be clouded by the fact that the liberalisation and deregulation process has not met consumer objectives but has instead been driven by market economics. The process will ensure that the industry aims to operate efficiently – a clear change from the former monopoly structures.
Conclusion
The question therefore becomes: Which scenario reflects the likely future developments in the market? Several factors and indicators influence our opinion. The first two scenarios describe various developments that have one common theme: the concentration of market power in the hands of a few pan-European utilities, and the struggle for survival of the smaller players in an increasingly oligopolistic market. We have seen similar developments in other industries, such as telecommunications, pharmaceuticals and chemicals. The future energy market will most likely embody elements of these scenarios.
