· A transforming deal in the German utilities sector is indicative of radical reshaping of the structure of the European and possibly global sector—it may spell the end of vertical integration where one company owns and operates all assets through the value chain from power generation over networks to retail & supply
· Scale matters for risk mitigation, profitability, innovation and growth
The deal and why it matters
E.ON is Germany’s second largest power supplier with 5.3m customers. In 2016, the company has spun-off its power generation business into a separately listed entity, Uniper, in which it kept a 47% (sold to Fortum early 2018). E.ON still owns a portfolio of nuclear plants and renewable assets. It operates 19% of Germany’s power distribution networks.
RWE is a power generator with a large thermal asset base dominated by coal plants (lignite/hard coal). The company spun-off its networks, renewables and supply business into a separately listed entity, Innogy, in 2016.
Innogy is Germany’s largest utility by market capitalization. It is largest power retailer with 6.8m customers and the largest grid operator in Germany. It was spun-off from RWE in Q4 2016 (see above). The company owns Npower, one of the big six energy suppliers in the UIK.
RWE will sell its 76.8% stake in Innogy, the renewables and network business that RWE spun out in 2017, to E.ON in exchange for a 16.7% stake in E.ON by means of a 20% capital increase by E.ON. RWE will further receive E.ON’s renewables business.
The transaction is important for Germany and the sector in the sense it aims to achieve what has been longed for since the 1990s: a stable structure for the German utilities sector, with sustainable market leaders. The German sector has turned in circles from the nascence of E.ON through the merger of former Veba and Viag in the late 1990s, over attempts of external growth within Europe and beyond (RWE/Thames Water, E.ON/Endesa), to the corporate splits of this decade and finally the return to larger entities.
The German utilities have had to compete with national champions in other European countries and been subject to takeover speculation at times when strategies were particularly muddled and unsuccessful as the industry needs to get to grips with energy transition. On the road, several solutions have been thought up. This transformational deal could lead to recovery in a sector that was at risk, in a challenging external environment (political risk, energy transition and overcapacity). Euler Hermes currently rates the wider energy sector in Germany as 3 or sensitive.
This restructuring set the base for the bricks and mortar assets of German utilities, conventional power generation, to be brought back to economic sustainability. This does, however not mean, that smaller actors will not continue to struggle with profitability and become victims of market forces or consolidation.
Large scale centralized power generation, and consumer-focused supply business
The deal could set a precedent outside of Germany, in Europe, and the world. Traditionally, power and gas were vertically integrated across the value chain from production all the way to retail and supply. We expect that this integrated value chain will break up and two very distinct businesses will emerge: Large scale centralised power generation, and consumer focused supply business. While the details are by far beyond the horizon of this paper, each of those businesses likely will change beyond recognition from their current state.
Figure 1 Streamlining of the industry
Figure 2 Outperformance of scale – market capitalizations of major utilities
Figure 3 Shift in power generation portfolios
The model suggested by the deal could serve as blueprint:
- The divide between upstream and downstream may be enacted elsewhere in Europe by corporates. Note that in the US, the regulatory model supports integration.
- Regulation and policy across Europe may take note. This notably entails regulatory risk for the UK sector. Policy makers have already acted on perceived market deficiencies in supply with a price cap and publicly expressed concerns over vertical integration have been plentiful.
- Restructuring of supply may accelerate.
The next immediate conclusion from this deal is: scale is important in the utilities sector. The deal was at least partially defensive. The quest for scale does have also its logic in a sector that is characterised by capital intensity and renewed ambition for growth.
This deal implies a conclusion that large scale renewables belong into the upstream portfolio of generators, as opposed to the supply or networks company.
With diversified portfolios, generators will hedge risk and be better positioned to capture market opportunities such as:
- Exposure to growth from renewables
- Portfolio diversification in order to adapt to a market increasingly driven by renewables
- Reduction of carbon content of the fleet through adding low carbon technologies
- Hedge against coal closure
There will no doubt be new challenges. Most importantly, the natural hedge that generators derived from integrating with supply businesses is no longer available.
As a consequence, commodity risk and earnings volatility increases for a stand-alone supply business. Renewables mitigate market risk by closer aligning portfolios to future market structures. While there is compelling logic in the remaining business model of Innogy, i.e. networks and supply, we do not see such businesses completely deprived of risk, particularly supply.
The most important benefit of this restructuring is scale in the supply business; grid synergies are not immediate. Over time, as energy transformation progresses, an combined supply and grid business could be positive in terms of smart grid development and integration. It is also worth noting that a standalone supply business is exposed to input cost volatility:
In absence of natural hedge from an owned generation portfolio as would be the case with vertical integration, the business is now fully exposed to wholesale power prices.
There is possibility for commodity price pass through to end customers, but history has shown that it is not perfect. And, to varying degrees in function of the respective political sensitivity in any given country, there may be political and eventually regulatory backlash
Potential for financial strength
Power generation is capital intensive, and even if renewables are less so, they still absorb large amounts of capex.
This deal happens at a time where power prices have greatly recovered and assets returned to profit. But not long ago only the much diversified generators were able to deliver profits during the sustained phase of commodity price weakness.
Figure 4 Leverage in the global energy and European utilities sectors
Execution of this deal will set the German sector on course for a benchmark in terms of strengthening balance sheets and risk reduction.
There may well be other utilities in Europe following suit. This will also contribute to risk perception in the global energy sector. Consolidation and M&A will continue to drive the outlook of the sector. Companies will enter into transactions for defence, adaptation of business models and renewed growth.
We estimate that the European sector could deploy growth funds in the order of EUR75bn , capex and M&A included (see our Global sector report – “Energy – growth now in your sector”, published February 2018)
Figure 5 Leverage in the global energy and European utilities sectors