This article examines how market dynamics requires companies operating within the European utilities sector to make constant adjustments to their business model. Also, we will analyse the consequences of market developments and the future challenges in strategic management, mainly from a merger and acquisitions perspective.
By Dr Taco C.R. van Someren & Hans Bongartz, KPMG's Dutch Energy & Natural Resources Practice.
In the coming years, business innovation will dominate the utility sectors as a result of advancing liberalisation in the energy market, which will become a reality across the entire European Union1 in 2007. This round of organisational renewal was initiated by a small number of visionary companies some years ago; now, the consequences of the then revolutionary decisions are becoming increasingly clear. The changing market dynamics are caused by the transformation of government dominated monopoly markets into regulated free markets. One of the business decisions that stands out in this process concerns mergers and acquisitions. We will illustrate how mergers and acquisitions have made a contribution, and will continue to contribute to the renewal of the business model.
Among other things, managers of utility companies have to find answers to the following consequences of the liberalisation:
Each of the above consequences of market liberalisation is a crucial renewal in itself. An additional factor for the utility sector is that these challenges and opportunities present themselves at almost the same time and must all be tackled to guarantee success in both the short and the long term. In the remainder of this article, we show how utility companies are meeting these challenges and opportunities by means of business innovation. These innovative growth periods can be illustrated with the aid of so called S-curves (see Figure 1). We distinguish three periods that present the development of this business sector towards a full market economy:
The following describes each one of these periods, at the same time indicating the corresponding market and other developments which have to be incorporated in the strategic policy in order to achieve a successful renewal of the business model.
1. The period up to 1995: municipal optimisation
Right across continental Europe, but also in other parts of the world, the utility markets were characterised by municipal and provincial monopoly situations until around 1995. In the UK, the energy markets were already fully liberalised at the end of the 1980s, but that was an exception in continental Europe, which, until 1995, would only be followed by Norway in 1991. The continental European utility companies were almost without exception part of local authorities; and competition was effectively non-existent because activities were carried out in a natural monopoly situation. At most there existed an aspiration for technical optimisation. Guarantee of supply was the most important objective for the utility companies: the strive for efficiency, development of alternative forms of energy and product or service development played no further role.
During this phase, up to about 1995, a number of European utility companies were already proactively busy with the implementation of innovations to prepare themselves for the moment that liberalisation would open up the European continental markets. These companies were mostly situated in the EU countries that were the first in the subsequent years to start liberalising their gas and/or electricity markets: Sweden (1996), Finland (1997) and Germany (1998). Their visionary managers aimed to bring about a strategy of scope maximisation within the restricted market opportunities at the time by integrating municipal companies into the first multi-utility businesses with activities in the gas and electricity production and distribution, water and waste segments.
As a result of these innovative activities by the pioneers, the not-so-active companies were also forced to consider their own strategy, particularly in the countries that were liberalised early. A number of them implemented similar strategic steps in order not to fall too far behind. In a number of other European countries (such as the Netherlands, where liberalisation was still some years away), the local companies had far fewer opportunities to consolidate themselves on the domestic market in preparation for the European consolidation that would inevitably follow in the long term. As we will see below, these differences in Europe would, in the next phase, also lead to a breakaway group and a group of followers in the battle for the European energy market.
2. The period from 1995 to 2007: increasing scale & scope
Commencing in approximately 1995, we see a number of European countries starting the process towards liberalisation and privatisation that was launched in Sweden and Germany in 1996 and 1998 respectively. From that moment, there is a considerable increase in cross border merger and acquisition activities, as clearly illustrated by Figure 2. During the first years of this phase, the main aim of the acquiring utility companies was to increase their scale and scope. The first priority was to purchase the largest possible market share, both domestically and internationally. However, this did not yet imply that the acquiring companies served their markets to the optimum as far as innovative strength, development and renewal of the business model, service portfolio and market approach are concerned. Usually, the companies did expand significantly and market positions were, indeed, taken up; however, the coherence between the existing and acquired entities (in both geographical and operational sense) was often lacking, so that the calculated synergy effects were disappointing. This means that there were significant inefficiencies.
In addition, the opening up of the market resulted in a drastic change in the purchasing pattern of both major industrial customers and individual consumers: apart from the delivery of commodities such as energy or water, there is now also an increasing demand for more service and tailor-made solutions, such as purchase optimisation based on consumption patterns. This is expressed in the slogan "from kilowatt to comfort". The guarantee of delivery remains a key criterion in the customer’s choice. Over and above that, however, new services and products are needed to meet the changing customer demand. This swing is supported by pursuing an active brand-name policy and expensive advertising and image campaigns. Because winning new customers and retaining existing customers at the same time are both crucial in a liberalised market.
During the period from approximately 1997 to 2007, we can identify three main directions in the strategies of utility companies:4
Efficiency management
Efficiency management can be divided into three categories: cost efficiency, organisational excellence and risk management. Proper management of these three elements is the essential prerequisite for successful additional growth on the second growth curve (see Figure 1).
Cost Efficiency: Energy (and also water, for instance) is basically a commodity, which means that price competition will be an important factor in overall competition. The liberalisation ensures that the prices remain under pressure, which, in turn, forces utility companies to introduce lower costs in order to keep the margins up to par.
Organisational Excellence: In the same manner as cost-reduction programmes, organisational changes can contribute towards bringing down operating costs. Furthermore, they should enable increased internal efficiency and lead to a more effective response to market changes. Within this push for efficiency, a lot of attention is also paid to the introduction of quality assurance programmes, such as EFQM, for ISO 9000 and ISO 14000, to process optimisation in all sorts of areas, and to the improvement of Customer Relations Management (CRM) and Management Information Systems (MIS). These also increase the transparency for management, resulting in better and quicker decisions being taken.
Risk Management: The liberalisation of the energy markets compels managers of utility companies to improve risk management in all areas. In particular, the management of the relatively "new" risks, such as those in the fields of energy trading, market price development, and supply obligations to switching customers, have gained a lot of attention. Furthermore, regulatory pressure in general increases in countries during and after the liberalisation process. Typically, a sector watchdog is installed, for example in the UK (OFGEM) and in the Netherlands (DTE). The risk of non-compliance in addition to the other "new" risks has become a relevant issue.
These three efficiency aspects are, indeed, important and have cost companies a lot of effort. However, they are not enough for survival in a market that is being liberalised. Efficiency measures are simply essential measures, more so because they mainly concern the cost aspects of the company. The greatest challenge, on the other hand, concerns the income aspect, where new customer issues and adjacent value chains offer enormous growth opportunities. Therefore, it is logical that many European utility companies have chosen an explicit growth strategy in recent years. We also anticipate that this growth strategy will continue in the coming years.
Growth & globalisation
The period from around 1997 to the present is characterised by opportunities for growth and the simultaneous appearance of innovations of all kinds. As we will see below, the utility companies to a large extent exploit these growth opportunities and innovations by conducting mergers and acquisitions at home and abroad. In this context, the familiar growth categories can be applied:
In sequence, we will examine each one of these categories with respect to their role in the growth strategies of European utilities and the share of mergers and acquisitions in this context.
Products, Services & Markets
We saw new products and services developed during this period, initially in energy or water related services but then extending the brand in to new areas for utilities such as banking and insurance. For consumers, this can entail all sorts of "comfort services", such as repairs, security or maintenance of the central heating boiler. For business customers, this may include industrial facilities services (offered by E.ON, among others), or a range of new types of contract, focused on the consumption and need pattern of individual customers. These, in fact, are all examples of forward integration in the value chain, i.e. in the direction of the customer.
The potential scope for utility companies has increased enormously during the recent years of liberalisation of the European market. In this context, some companies chose to differentiate by means of:
A multi-utility strategy in which, for example, water, waste and cable services are also provided. The German giant, RWE, for instance, recently took important steps in its expansion strategy in the water sector: through acquisitions including Berlin Wasser and, recently, Thames Water (UK), and the planned acquisition of American Water Works (US), RWE is today number one in the water market in Germany, the UK and the US.
Entering entirely new markets. For example, the trade in electricity and, more recently, the trade in green certificates for generated sustainable energy or in emission rights for CO2. For instance, Nuon is one of the biggest energy traders in Germany, without having acquired substantial assets in the country.
As utilities extend into areas beyond their traditional core companies look to acquisitions and alliances. Examples of business sectors where cooperation is sought include:
A liberalising market encourages new entrants: in a small country such as the Netherlands, at least 10 new providers with no ties to existing domestic or foreign energy distributors have entered the market in the last three years. In most instances, these providers focus specifically on niche markets; for instance, many new Internet and other providers have entered the free Dutch consumer market for green energy. These new players can change the rules of the game, introducing new dynamics to the consumer behaviour and price patterns. New entrants cause the battle for the individual customer to intensify.
Technology
Various new technologies are emerging, without it being predictable at present which ones will ultimately become dominant. This means that companies have to place their bets on different horses if the expectation is that certain technologies will have a major influence on the future of the utilities sector. New technologies on which the utility companies are placing their bets include Powerline Technologies (PLT: data communications via the electricity network), sustainable energy (including wind turbine plants), fuel cells and other decentralised technologies. Two basic choices have to be made concerning these new technologies: developing it oneself or in partnership with one or more other parties. An interest is often acquired in one of these specialised technological companies in order to remain flexible if the technology turns out to be unsuccessful. From time to time, technologies are also purchased, as in the case of NUON, which has gained access to the broad technological application of active carbon and filter membranes through the acquisition of Norit.
The development of these technologies, whether or not together with partners or through acquisitions, can be seen as an integration strategy (a technology push) to ensure that, should a technological breakthrough result in a relevant market demand, the company is ready to provide the new technology to customers, thus retaining or expanding their customer and market share.
Organisational Innovation
Under organisational innovation, we include the development of a network organisation, for instance. The most common forms of network organisations employ the network of participating interests, subsidiaries, joint ventures and collaboration agreements in order, for instance, to reach different types of customer groups (channel marketing) or to develop specialist R&D projects, such as the fuel cell. Sometimes, new business activities, such as trade in energy, are launched in a similar way. Outsourcing, such as that of call centre activities, workplace management or back-office processes, is also a form of organisational innovation. The core business can be strengthened through the disposal of non-core activities and the purchasing of, or participation in, new activities.
Moreover, internationally operating utilities also have experience with different local operational management models and best practices, and can use this experience for reference in their further growth in other, new markets. The organisational competencies thus created can help companies cope better with a variety of problems in different cultural contexts. The problem solving and learning capacity of such a company gives it an enormous advantage over the local competitors and other, less internationally oriented companies.
Geography
Cross-border acquisitions or mergers are the ultimate means for organisations wishing to rise above their local or regional market. The maximum allowed domestic magnitude plays an important part in this. Within the EU, there are large differences between the permitted magnitudes, mostly determined by the size of the member state. For example, in Italy (Enel, ENI-Italgas), France (EdF/GdF) and Belgium (Electrabel), it is possible to grow very large in almost monopolist market conditions because there is little or no liberalisation. And the fact that their size, in turn, is to their advantage when it comes to acquisitions in countries that do privatise and liberalise, should be obvious. On the other hand, the potential to grow into a major European player through mergers and acquisitions in the Netherlands is far smaller than in a country such as Germany. The Essent-NUON or Essent-Gasunie combinations, both prohibited by the Netherlands Competition Authority, would not even occupy a top-10 position in Europe. Thus, significant differences remain between domestic growth opportunities offered to the utilities in the different European countries. For the creation of a level playing field, it is vitally significant that EU ministers recently reached agreement with respect to the complete liberalisation of the European energy markets. Even France has conceded: the business market will be liberalised commencing from 2004, and the private domestic market with effect from mid-2007. However, a properly functioning European electricity market will stand or fall with sufficient import capacity for high-voltage transmission, in addition to good access to the distribution networks under reasonable conditions and at reasonable prices. Only then will the ultimate objective, price benefits for consumers and businesses, become a reality.
All four different categories of growth have resulted in the proactive companies expanding enormously in scale and scope in recent years (see the top 20 acquisitions in Europe in Figure 3.) and they are still continuing to expand. In fact, many companies have followed the strategy of "maximum growth in scale and scope" up to now, which is illustrated in Figure 4. by the number of transactions since 1997 of the European top 10 utilities.
The result of this almost unrestrained growth is that some companies are currently busy with a re-evaluation or assessment of the strategy. The question is whether all these business activities acquired together under one umbrella still fit in with the original strategy, or whether some readjustment is required. In this context, an important factor is also the fact that astronomical amounts were often paid for these companies, which were usually acquired in fierce auction procedures. The success or lack of it on the acquisition markets also plays an important role in this context: for instance, in mid-2002, Endesa completely withdrew from the northern European market after being unable to acquire the sizeable Stadtwerke in Germany and the acquisitions of REMU and Intergas by Endesa were also found to be unattractive after a drawn out legal tug of war in the Netherlands. Further examples of companies withdrawing include Fortum, which left Germany in 2001, and TXU, which previously sold its activities in the UK (as have other US utilities like Western Power Distribution and American Electric Power) is currently disposing its German companies in Braunschweig and Kiel. Braunschweig was acquired only six months ago. A further reshuffle of portfolios in Europe is likely, now that the gun smoke of almost five years of mergers and acquisitions is beginning to disperse and it is becoming clearer and clearer that optimisation will be required within the activities portfolio in order to achieve the desired returns.
Defining the Core Business
The price paid for the tempestuous growth is that more and more companies are beginning to realise that not every renewal was equally successful. In the one instance, the expectations of the geographic international expansion did not pay off and, in the other instance, not every market penetration and product and service development turned out a success. This means that the scale and scope of activities are currently being scrutinised, which is already clear to see at some companies (TXU, Endesa, Fortum, RWE, E.ON). We expect that many large utilities will implement a similar re-evaluation in the coming years to around 2007, after which, commencing in 2007, a subsequent phase of renewed focus and growth will unfold. There is more than enough money available to do it, and there will be no shying away from further geographical diversification: take E.ON, for example, which has indicated having a war chest of approximately EUR 30 billion at its disposal (excluding income from the sale of Stinnes, Degussa and Viterra, among others) and particularly wants to achieve further growth in the US, where it aims to become a top 3 player in the long-term.
3. The period after 2007: focus & continued innovation
The differences in the speed of liberalisation and privatisation in the period from 1995 to today, plus the strong growth strategy of a number of major players, has resulted in the emergence of a number of leaders that have grown into dominant players and a large number of mostly medium-sized utilities that have only more recently started to provide additional services or adjacent activities. As far as timing is concerned, we suspect that it is now too late to muscle into the European top league. The distance between the top 3, Suez, RWE and Electricitie de France and the number 10, Scottish Power, is so great that it is almost impossible to bridge independently. Merging with other equal parties could be an option to get into the sub-top. Selling to a major European party can also bring advantages for the company, employees or shareholders, depending on the goals of the different stakeholders. A niche strategy will once more be interesting to other utilities: those who know that they will not belong to the European top 10 in 2010 can chose to become a top 3 European player in, for instance, the field of sustainable energy.
The future for European Utility Companies
The last years, since approximately 1995, have seen enormous dynamics in the once so quiet utility sector in Europe. Countries liberalise and privatise, creating opportunities and threats for local and international players - also creating the necessity for flexibility, adaptability and innovation of the business model as a way of surviving. As a further strategic reaction to the opportunities presented in the marketplace, merger and acquisition activity has increased dramatically. This was one of the drivers of a constant organisational renewal process. This has been going on for about seven years.
We foresee ongoing, but strategically more focused activity in the next, approximately five years as European liberalisation is coming to completion. There is clearly a group of frontrunners: the very large cash rich (multi) utility groups, having the power to remain on the forefront of the developments. These powerful companies are capable of further empowerment, because the gap from the top league to the rest has already become very difficult to bridge. This means that business models will have to be renewed in order to give answers to ever changing market conditions.
These frontrunners are the first to expand heavily into geographical areas outside of Europe, starting in the US. The question will be to what extent they will be able to make this truly international business model into a financial and organisational success. If they can, the empowerment of the powerful will continue, in all areas. Geographically the really interesting growth market in Asia could come into their focus next. The war chest is available, the innovative capacity is, but are the former local municipal utilities able to transform their business model in such short period of time to meet the challenges they face in all (geographical) markets? Time will tell.
Footnotes 1. Before the enlargement of the European Union with the new member states as of 2004. 2. Van Someren, Innovatie, Emulatie en Tijd. De rol van organisatorische vernieuwingen in het economische proces [Innovation, Emulation and Time: The role of organisational innovation in the economic process], Tinbergen Institute/University of Amsterdam, 1991. 3. Completed transactions in utilities and electric services industries (including minority acquisitions and disposals). 4. These main strategic directions were also identifiable during periods of liberalisation in other business sectors, e.g. the telecommunications and aviation industries. 5. Completed transactions in utilities and electric services industries (only majority acquisitions). 6. Completed transactions in utilities and electric services industries (including minority acquisitions).
Hans Bongartz is an Associate Director and Head of KPMG's Dutch Energy & Natural Resources Practice. E: bongartz.hans@kpmg.nl T: + 31 (0) 20 656 7839
Dr. Taco C.R. van Someren is a Partner responsible for Business Innovation and Corporate Renewal, specialising in the Energy & Natural Resources Sector. E: vansomeren.taco@kpmg.nl T: + 31 (0) 20 656 8076
