In response to increased competition in power generation, investor-owned utilities (IOUs) have engaged in a wave of mergers and acquisitions during the past decade, resulting in some very large IOUs. In contrast, some IOUs have exited the power generation business by selling their generation assets to an independent power producer (IPP), or by transferring them to an unregulated subsidiary within their company. The purpose of these contrasting strategies is to improve and solidify a position in the new competitive industry. It is too early to determine, however, the effectiveness of these strategies on the industry and their benefits to electricity customers.

Recent mergers are classified broadly into two categories, each category representing a fundamentally different reason for merging. The first category includes mergers between IOUs or between IOUs and IPPs. These mergers are motivated by the desire to increase power generation capacity and/or transmission and distribution capacity and in general become a larger electric utility. Most utility executives take the position that to compete successfully in today's electricity market a company must be relatively large.

The second category includes mergers between electric utilities and natural gas companies. Companies entering into these types of mergers are seeking to become a regional or even a national company that produces, transports, and markets electricity and natural gas. These are called convergence mergers because they represent the increasing number of companies that own both electricity and natural gas assets and are active in both industries. Each of these categories of mergers is described followed by an examination of recent divestitures of power generation assets by IOUs.

Mergers and Acquisitions Between IOUs and IPPs
From 1992 to April 2000, 35 mergers or acquisitions have been completed between IOUs or between IOUs and IPPs. Twelve mergers have been announced and are now pending stockholder or Federal and State government approval (Table 14).⁽¹⁾ The size of IOU mergers, in terms of value of assets, is also increasing. Between 1992 and 1998, only four mergers were completed in which the combined assets of the companies in each merger were greater than $10 billion. More recently, eight mergers completed in 1999 or 2000, or pending completion, each have combined assets greater than $10 billion.

One of the effects of this wave of mergers is that there are fewer operating electric utilities. In 1992, 172 operating utilities owned generation capacity in the United States. By the end of 2000, the number of operating utilities owning generation capacity will decrease to an estimated 141 (Table 15). Power plant divestitures, discussed later in the chapter, have also reduced the total number of IOUs that own generation capacity.

The majority of operating electric utilities are wholly-owned subsidiaries of public utility holding companies.⁽²⁾ The effect of mergers on consolidation of the industry is more evident when ownership capacity is aggregated by holding companies. In 1992, there were 70 electric holding companies owning 78 percent of the IOU-held generation capacity. By the end of 2000, the number of electric holding companies will decrease to 53, and the generation capacity they own will increase to about 86 percent of the total IOU-owned capacity, primarily  because  of  mergers  and  acquisitions.  This statistic suggests that relatively large companies are becoming even larger.

Although many electric utilities see a need to grow through mergers, others do not. Of 82 electric utilities (53 electric utility holding companies and 29 independent electric utilities) in 2000 (Table 15), 56 (approximately 60 percent) have not been involved in a merger since 1992 and have not announced plans to merge. This suggests that even though the merger trend is strong, most IOUs believe consolidation is not necessary to remain competitive in the industry in spite of the fact that those companies choosing to merge are acquiring a larger share of the industry's assets.

Figure 29. Concentration of Ownership of Investor-Owned Utility Generating Capacity, 1992 and 2000

The absolute number of companies provides insight into consolidation trends, but concentration of generation capacity ownership is perhaps more indicative of consolidation.⁽³⁾ As a measure of consolidation of the IOU sector, concentration indicates the extent to which total capacity ownership is dispersed among companies. The data suggest that generation capacity owned by IOUs has been concentrated in the hands of a few companies, and that mergers and acquisitions are increasing the concentration of ownership within the IOU sector. In 1992, the 10 largest utilities, ranked according to generation capacity, owned 36 percent of all IOU generation capacity; by the end of 2000 the 10 largest companies' share will increase to an estimated 51 percent (Figure 29). Evidence of consolidation among the 20 largest companies is even more compelling. In 1992 the 20 largest companies owned 58 percent of total IOU generation capacity; by the end of 2000 their share is expected to increase to approximately 72 percent.

Mergers and acquisitions also cause consolidation of ownership of the Nation's transmission and distribution systems. However, the outcome of this trend is unclear because many utilities may transfer ownership of their transmission system to regional transmission organizations in compliance with the Federal Energy Regulatory Commission's (FERC's) Order 2000.

Reasons for Mergers and Acquisitions Among Electric Utilities
Most, if not all, utility executives who have directed their companies through mergers, argue that electric utilities must be relatively large to be competitive.⁽⁴⁾ This position underlies most of the mergers and acquisitions recently completed between IOUs. Why does size matter? The thinking is that larger companies are able to achieve economies of scale. By combining resources and eliminating redundant or overlapping activities, larger companies hope to benefit from increased efficiencies in procurement, production, marketing, administration, and other functional areas that smaller companies may not be able to achieve. For example, a larger company, because of a high volume of purchases, may be able to negotiate a lower price from its fuel supplier than would be available to a smaller company. Cost savings resulting from increased efficiency can be passed to the utility's customers through lower electricity rates.

Whereas utility executives argue that a merger or acquisition will improve the efficiency of the combined company, experience indicates that efficiency improvements are not guaranteed. One study reported that only 15 percent of mergers and acquisitions achieved their expected financial objectives.⁽⁵⁾ Incomplete or underdeveloped plans to integrate the companies was noted as a major factor for not achieving the objectives.

A company's strategic objectives are also factors in the decision to merge. Does the merger complement or enhance the strategic objectives of the company is a question asked by company executives in identifying merger partners. Strategic objectives are company specific and depend upon the merging companies' particular circumstances. Building on core competencies, securing more customers, consolidating transmission and distribution facilities, diversifying power generating capability, and acquiring additional managerial and technical expertise are mentioned often as reasons. These strategic reasons, however, relate to the desire to remain competitive in the rapidly changing electricity industry.

Convergence Mergers
Increased competition has pressured electric utilities and natural gas companies to combine operations in order to become more efficient, to diversify products, to share expertise and experience in energy markets, and to take advantage of the growing use of natural-gas-fired power plants. Combining electric utilities and natural gas companies is called convergence of the industries, and many companies that once sold only electricity or natural gas now sell both electricity and natural gas, or are involved in other aspects of both industries.

A combined electric and natural gas utility is not something new to the industry. Many IOUs sell both electricity and natural gas to retail customers. What is new about the recent wave of mergers is that many of them are between electric utilities and natural gas production, processing, or interstate pipeline companies. These types of mergers expand greatly the business opportunities for electric utilities.

From 1997 through April 2000, 23 convergence mergers involving companies with assets valued at $0.5 billion or higher have been completed or are pending completion (Table 16).⁽⁶⁾ No one knows for certain how long this trend will continue, but many industry observers agree that more convergence mergers will take place as deregulation of the electric power industry continues and electric and natural gas companies seek to diversify their businesses.

Strategic Benefits of Convergence Mergers
The natural gas industry has a relatively complicated structure that, depending on one's classification scheme, may consist of four major corporate segments (Table 17).

Some of the major natural gas companies are vertically integrated, having exploration and production, pipelines, local distribution, and marketing components. The majority of the companies are not vertically integrated but specialize in one or two areas. Local distribution companies (LDCs) are the largest segment of the industry, with approximately 1,400 LDCs operating in the United States. The benefits to an electric utility of a convergence merger depend on where the gas company is located in the production cycle. An analysis of the current wave of convergence mergers shows that the benefits of the merger generally fall into one or more of the following areas.

Strengthen Wholesale Marketing and Trading Operations: Deregulation of the electricity and natural gas industries has created spot markets for wholesale electricity and natural gas, as well as markets for buying, selling, and trading financial instruments for risk management. In competitive commodity markets, prices for the commodities (in this case, electricity or natural gas) are sometimes volatile. Risk management, such as buying futures contracts for electricity, helps reduce the risk of price volatility. Many electric utilities and natural gas companies realize that there are similar and related techniques for electricity and natural gas marketing and trading in spot markets, and are merging to form larger organizations specializing in electricity and natural gas. This provides the opportunity to sell a diversified line of products to their customers, and it can help lower administrative and processing costs. It also facilitates arbitrage between electric power and natural gas prices.

One of the most frequently cited reasons for a convergence merger is the transferring of a gas company's experience in marketing and trading to an electric company that is relatively new in competitive markets and commodity trading. The gas industry has been deregulated since the 1980s, and over that time surviving gas companies have developed skills and experience in working in competitive energy markets.

Diversify Products and Expand Retail Markets: Most electric utilities believe that to remain competitive they need to offer more products and services to their retail customers. State-designed customer choice programs, which allow retail customers to select their energy suppliers, motivate utilities to differentiate their products from their competitors' products. One strategy to accomplish this is to merge with a local gas distribution utility and offer both electricity and natural gas services to customers. The idea of one-stop shopping appeals to some customers, and combined marketing and delivery systems can also help reduce the utility's billing, metering, and other administrative costs.

In addition to diversifying products and services, many utilities see convergence mergers as a way to increase market  share,  although  this  concept  also  applies to mergers involving only electric utilities. Increased market share should lower per-customer costs by spreading fixed costs over a larger customer base. Utility distribution systems have a large fixed-cost component.

Another benefit from convergence mergers is the potential for cross-selling electricity to natural gas customers and natural gas to electricity customers. The extent to which the customer base of the merging companies does not overlap represents the potential for increasing market share by cross-selling.

Expand and Strengthen Access to a Fuel Supply for Merchant Power Plants: Electric utility holding companies are merging with natural gas companies that specialize in natural gas production, processing, pipeline operation, and storage. These are called upstream and midstream functions in the natural gas industry parlance. Distribution to the ultimate customer is a downstream function. Electric utility mergers with upstream or midstream natural gas companies position the new company to benefit from the growing demand for natural gas stimulated by the projected growth in gas-fired power plants across the country.

Figure 30. Cumulative Electricity Generation Capacity Additions Through 2020

Because of the rising demand for electricity and the retirement of older power generation units, 300 gigawatts of new generating capacity will be needed in the United States by 2020 (Figure 30). Assuming an average plant capacity of 300 megawatts, a projected 1,000 new plants will be needed to meet electricity demand and to offset plant retirements. Ninety percent of that capacity is projected to be natural-gas-fired or dual-fired gas and oil combined-cycle or combustion turbine technology. These technologies have lower capital costs and operating and maintenance costs than other technologies, and they more easily meet local and Federal Government emissions constraints, which are expected to tighten in the future. Electric utilities that own upstream and midstream natural gas resources will be positioned to compete for customers in growing natural gas markets brought on by the increase in demand for gas-fired plants. Also, by owning upstream and midstream gas resources, a company can expand its range of products and services and build a marketing strategy focused on a customer's total energy needs.

Regulatory Review of Electric Utility Mergers and Acquisitions
Electric utility mergers or acquisitions of substantial size go through a review process involving a number of Federal and State Government agencies (Table 18). At the State level, the public utility commission or its equivalent reviews the merger for potential anti-competitive effects and potential cost savings. States may also review the merger's effect on a utility's stranded costs,⁽⁷⁾ an issue brought on by industry deregulation. Because most electric utility operations cross State boundaries, it is not uncommon for multiple States to review a merger. The extent and depth of the review can vary widely between States, depending on the merger's expected impact in the State and the resources available to conduct an evaluation.

Federal review of a proposed merger may involve up to five different agencies. Either the Federal Trade Commission (FTC) or the Antitrust Division of the Department of Justice (DOJ) could conduct a review to determine whether the merger is consistent with antitrust laws. Recently, the Antitrust Division of the DOJ, rather than the FTC, has reviewed electric utility mergers, but for most electric utility mergers the DOJ relies on FERC to take the lead in evaluating the competitive effects of the merger. The DOJ limits its role to participation as an interested party.⁽⁸⁾ The Securities and Exchange Commission (SEC) can become involved in a merger or acquisition when a holding company gains control of 10 percent or more of the voting securities of another electric utility. If that is the case, the SEC reviews the merger for compliance with requirements of the Public Utilities Holding Company Act of 1935. The Nuclear Regulatory Commission (NRC) reviews a proposed merger or acquisition when it involves the transfer of a nuclear power plant operating license.

Of all Federal Government agencies involved in reviewing a proposed merger between electric utilities, FERC's review is probably the most extensive, covering the merger's potential effects on competition in the industry, electricity rates to customers, and regulation. FERC sometimes will request merger applicants to prepare special reports showing the merger's effect on market power or the cost savings and efficiencies that are expected from the merger. These reports and other documents, such as public comments about the merger, are available on the Commission's website (www.ferc.fed.us). Depending on the level of public interest, the size of the merging companies, and the merger's potential impact on the industry, FERC may hold public hearings to obtain information and to discuss important issues associated with the merger.

Divestiture of Power Generation Assets
The previous sections discussed mergers and acquisitions and their effects on the structure of the industry. Recent divestitures of power generation assets (i.e., power plants) by a number of IOUs is another type of corporate realignment that is changing the structure of the industry. Divestiture of generation assets is defined as  the sale of assets to another company, or the transfer of assets from the regulated utility subsidiary to an unregulated subsidiary within the company structure.

Over the past 3 years, IOUs have divested power generation assets at unprecedented levels. From late 1997 through April 2000, 51 IOUs (32 percent of the 161 IOUs owning generation capacity) have divested or are in the process of divesting 156.5 gigawatts of power generation capacity, representing approximately 22 percent of total U.S. electric utility generation capacity (Table 19). Of the 156.5 gigawatts, 86.2 gigawatts have been sold or are pending completion of the sale, 31.9 gigawatts are up for sale, and 38.3 gigawatts will be transferred by an IOU to its nonutility subsidiary. Some industry observers have estimated that ownership may change for up to 50 percent of total U.S. generation capacity (about 364 gigawatts as of 1998) over the next 10 years. No one can predict with certainty the volume of future divestitures, but more are expected as restructuring of the electric power industry proceeds.

The idea of an electric utility divesting generation assets can be traced back to before November 1996, when FERC issued Order 888 requiring electric utilities to allow access to their transmission lines to other electricity suppliers. As discussed in Chapter 7, FERC believed that access to transmission lines was necessary in order for a competitive power generation market to develop. Some industry participants believed, however, that open access to the transmission system would not be sufficient. When transmission line capacity becomes limited due to high usage, it is argued that utilities that own the transmission lines will favor power from their own generators over a competitor's generator. Many thought the answer to this problem was for FERC to require utilities that own both power generators and transmission lines to divest their power generation assets.

In Order 888, FERC took a less intrusive alternative to actual divestiture of generation assets by requiring functional unbundling. Functional unbundling is achieved when a company's organizational structure separates operation of and access to the transmission system from power generation. To comply with functional unbundling, electric utilities created an open access transmission tariff, established separate rates for wholesale generation, transmission, and ancillary services, and established an electronic information network that supplies information on the availability of transmission capacity to customers. All IOUs have complied with FERC's functional unbundling requirements and in some regions electric utilities have formed independent system operator (ISO) companies and turned control (but not ownership) of their transmission assets over to the ISOs. This action can be construed as a way of unbundling power generation from transmission.

Why Investor-Owned Electric Utilities Are Divesting Power Generation Assets
Even though all IOUs have functionally unbundled generation from transmission, and some have formed ISOs, many utilities have divested their power plants because of State requirements or as a result of strategic business decisions made by the utility. With regard to State requirements, States that are opening the electric market to retail competition view the separation of power generation ownership from power transmission and distribution ownership as a prerequisite for retail competition. Some States have passed laws requiring utilities to divest their power plants. California, C