This is the first in a series of six blogs that summarize discussions on the U.S. utility and power sectors. The discussion took place at the virtual 34th Annual Power and Gas M&A Symposium on February 24, 2021.

Jonathan Bobinger, a Partner at international law firm Baker Botts, moderated an interesting Investment Banker’s Roundtable with three industry leaders: (1) George Bilicic, Vice Chairman of Investment Banking and Global Head of Power, Utilities, and Infrastructure at Lazard, (2) Jeffrey R. Holzschuh, Chairman of the Institutional Securities and Global Power and Utility Groups at Morgan Stanley, and, (3) Joseph G. Sauvage, Vice Chairman and Head of the Global Power Group at Citi.

The Roundtable focused on three main questions:

1. What do you see as the broader environmental, social, and governance (ESG) pressures on electric and gas utilities from their key stakeholders, such as banks, in response to regulatory shareholder and other pressures on those institutions?
2. What is the environment for power and gas M&A?
3. What role do you see power and utility companies playing in energy transition?

A few highlights:

• ESG issues matter and companies will set targets to align with the Paris Agreement and meet the growing requirements of bankers; this is not new for utilities, as they have been focused on stakeholder demands for some time.
• Gas LDCs are here to stay and there are more opportunities for transactions. Private capital could end up owning these businesses due to the nature of the cash flow profiles.
• A slow utility consolidation is expected with continuous activity on fossil, merchant, and natural gas-fired generation.
• The Special Purpose Acquisition Companies (SPACs) phenomena is robust and will spur the renewables segment.
• The traditional utility industry is small, and there are few attractive companies left — but there could be one major M&A transaction this year.
• We are likely to see a combination of organic and inorganic growth going forward. The organic opportunity created by electric vehicle charging, storage, hydrogen, and other renewables areas is large.
• Utilities are going to play a large role in the energy transition.

2. ESG pressures

   First, it is important to note that the EEI has done a great job of working with the Wall Street banks on ESG matters. There is a template on ESG disclosures, which includes carbon intensity and such, which has been developed with the banks and with EEI and their member companies.

3. Focusing on the Wall Street bank element as the key stakeholder, there are credit implications in terms of changing business models, the acceleration of coal retirement, and the question about the longevity of the gas LDC business in certain spots. The bank's regulators are focused on the credit quality of their portfolios. In turn, the energy industry is focused on the type of ESG information that the banks need.

4. Also important is how the stakeholders of big Wall Street banks are approaching ESG and their concerns about carbon intensity and meeting the Paris Climate Agreement. Banks are adopting policies around these issues, with the initial focus being on coal-fired generation. U.S. companies will have their own targets to respond to the pressures that the banks are seeing from their regulators and other stakeholders. Utilities have focused on stakeholder issues for some time, given the rate payer nature of the sector and the need to work in communities, so this is an area of strength for utilities. On the investment banking side, an entity’s sustainability rating and posture on carbon and other key ESG matters are always discussed today.

5. What are the transactional implications of the ESG focus on the gas local distribution company (LDC) business?

6. First thing, this is an enduring business as there isn't a technology or a solution that is practical to displace gas LDCs. There are opportunities to supplement what gas LDCs have historically done through renewable natural gas and, possibly over time, hydrogen, but the business isn’t going away.
   Regarding transactional implications, there is potentially more opportunity because, for example, electric companies ought to be evaluating their position in gas LDCs, since they trade a little bit differently.

7. Valuation levels have been affected because of the uncertainties in the business, however, and that is expected continue. In addition, particularly in some states, there is a lot of criticism about the business and concerns around the growth prospects around new construction and conversion of customers to natural gas.

8. There is also the potential for this business to be more in the hands of private capital that could end up owning these businesses because of the enduring nature of the cash flows. There could be someone in the sector who is a gas LDC, or owns gas LDCs, seeing this as an enduring business. The opportunity to acquire these assets is better now because prices are lower, and there may be a decision to be a scale-based company going forward. Another transactional implication, however, is that, with the noise around the business, the cost of capital is a little bit higher. So, financing costs around the transaction should be higher.

9. The environment for power and gas M&A

10. Regulated facilities: Despite difficulties given the history between a lot of the parties and the unusual nature of the industry where value was shared with rate payers, we will see slow utility M&A consolidation.

11. Fossil, merchant, and natural gas-fired generation: It is a tough marketplace as it is complicated and there is not a lot of depth to get transactions done. However, activity in this area is likely to continue.

12. Renewables: The SPAC phenomenon is robust, and that should continue at all sorts of different levels — across software companies serving utilities, renewables developers, new technology companies, energy services companies, and more.

13. Conventional generation: This has almost become a private equity business, but an important issue is identifying the next buyer. There have been some very creative approaches in terms of continuation funds, taking portfolios and carving them up, so private equity will likely continue to exit the business.

14. In addition, many expect rates to go up and inflation to re-enter. The performance of share prices has been quite poor relative to the S&P, which dampens M&A. There was a lot of activity this past year in separating assets or categories of assets to simplify some of the business models. This will likely continue to get multiple expansion in those places where the models become more pure play. There has also been a fair amount of activism in the space, although it hasn't always led to M&A.

15. What are the prospects for traditional utility M&A?

16. This is a relatively small industry, and the number of companies has been declining. That means two things: there are fewer buyers, and there are fewer attractive companies left to partner with or to transact. That said, there will likely be at least one significant M&A transaction this year, but it is very difficult, and M&A is really bespoke in the sector.

17. Looking back several months, there were maybe six or seven companies trading above 20x earnings, and a number trading 7 to 10 multiple ticks below. Some of the companies in the bottom quartile have done transactions, such as business separation transactions, and their share prices have moved in response. A fair number of companies at the top end have lost some of that PE multiple advantage. As other companies became more pure-play regulated, some made management changes and some restructured.

18. Where do you see growth in the industry? Do you see it as organic or through acquisitions?

19. It is going to be a mix of organic and inorganic. The capital expenditure numbers for the industry are large. We still see most companies announcing 6% to 8% annual growth numbers, but we are going to go through an economic recovery and probably get some additional support from Washington. The amount of money being spent on R&D and tech has been outsized in this space relative to history. The organic opportunity of electric vehicle charging, storage, hydrogen, and other renewable areas is large. For electric companies that have generation, there is growth around changing the generation fleet. There is organic growth for the gas LDCs around investing in system resiliency, pipe replacement, and such. As technology develops and the grid needs to function in a more dynamic way, there will be investment opportunities. The growth rates, plus the yield that is available in the sector, provides an attractive risk-adjusted total return for investors, and potential growth through M&A if the transactions are priced right.

20. Energy transition

21. The utilities are going to play a big role in the transition, as we have seen in Europe. The large energy companies clearly are including renewable sources and technological advances, so the industry has a good head start on some of the clean tech hydrogen storage and such. When transportation electrifies, the industry will build the infrastructure around it. With solar roof top, the industry has the customer base and the distribution, and will do very well in that space. There have been dedicated early-stage investment funds, which will be part of the answer.

22. The SPAC phenomenon is pushing value levels up to ones that are hard to support with traditional valuation analysis. It is creating more exit alternatives for private equity and other private capital investors around companies that fit in energy transition broadly. A positive dynamic of SPAC is that it is assisting in the gathering of capital to support these energy transition companies, and pulling forward or taking capital needs off the table, which facilitates the implementation of business plans, including some companies that are more a binary risk from a technology perspective. If the SPAC phenomenon continues, we are going to have more public companies. Those public companies will be in a sector that benefits from scale, either through horizontal or vertical integration. These post-SPAC companies will do what public companies do, which is to transact.