U.K. ELECTRICITY INDUSTRY

A REPORT OF U.K. ELECTRICITY INDUSTRY

 EXECUTIVE SUMMARY

The industry is liberalized with several electricity firms operating freely in the market. Companies acquire one another without restrictions with the aim of improving their market share. Others merge with the same objective. Maybe the only tough government regulation is the EU legislations on the environment. There are many methods of generating electricity i.e. power stations, nuclear, coal and renewables. Coal is one method that is not environmentally friends and the companies have been warned against emitting harmful emissions to the environment.

Mergers and acquisitions are associated with many financial issues. The financial statements would have to be prepared on consolidation basis, huge capital need be set aside and the companies must be ready to successfully grapple with the treatment of certain transactions like dividends, pre and post acquisition profits.

As much as acquisitions can be beneficial, there are also problems associated with it. The investor company and the acquired company may be incompatible in many aspects. Their policies and rules may be a complete contrast as is their cultural and ethical believes and practices.

The acquirers then needs to analyze, evaluate the company to be acquired and only make the acquisition plan if only and if the benefits outweigh the costs.[1] 

  RESEARCH OBJECTIVES / PROBLEMS POSED

During the research, one of the problems was the reluctance of the firms in being subjected into a study. Not all the questions were answered some most relevant information could not be obtained due to unavoidable circumstances. The cost of the research was also underestimated only to be found that it is costly affair.

 CONTENTS

1.0 Background

The term acquisition refers to a situation where one company purchases the shares in other one or more companies. This can be through cash or by issuing its own shares or a loan stock in exchange of the shares. This method of business combination is also referred to as “purchase method”. In an industry, there can be scarce resources that a firm may exploit but which it cannot singe handedly. Acquisition then becomes of essence for the company to capture a wide market and make use of available resources. In the UK electricity industry, there are a lot of government regulations especially the EU environmental legislation. This stipulates that companies should be wary of carbon emissions to the environment. This is likely to lock many of them that may not have complied with this legislation by 2015. A company in the industry can acquire more companies and widen its market share as a result of the exit of those companies that would not have complied with regulations.[2]

In acquisition, companies do not combine. The companies remain independent separate legal entities. However, there may be changes in control. A company can acquire effective control of another company by owing not less than 25% of the voting power in that company. In the UK electricity industry, acquisitions fall into three categories. These are the horizontal structures, vertical structures and mixed structures.

The horizontal structure is where one electricity firm owns directly controlling interest in more that one subsidiary. This may be illustrated as follows for illustrative purposes only.

 Interpreted, it would mean that power Gen has acquired 80% of the controlling interest in EDF, 70%in innogy (RWE) and 60% in Scottish power.

The vertical structure is where a parent company owns directly controlling interest in a subsidiary, which in turn owns directly controlling in another company. Assume that power gene acquired 80% of the shares in EDF. EDF also acquired 60% of the shares in innogy. This scenario can well be illustrated as follows:

  Powergen would have a direct controlling interest in EDF of 80% and has an indirect arithmetic interest of 48% in innogy (i.e. 80% of 60%). Even though the arithmetic interest of powergen in innogy is less that 50%, innogy is a sub- subsidiary of powergen. This is because powergen control EDF and EDF control innogy and therefore by extension, powergen controls Innogy.[3]

When a company acquires part of the shareholding of another, the other part is taken by the minority group and is referred to as minority interest. It is called minority interest because their holding is usually less than 50% shares of the company that has been acquired. As the net assets of a company are financed by share capital and reserves so the proportion of the ordinary shares, preference shares and reserves attributable to outsiders is calculated, and is shown as ‘minority interest on the liabilities side of the balance sheet of the holding company.[4]

One of the challenges of accounting for acquisitions is on the calculation of minority interest. To obtain the minority interest in EDF and innogy the proportion of ordinary shares and that those of preference shares held by the minority will first be established. The amounts are then added. Then the minority’s share of each reserve (i.e. capital and revenue reserves) in the subsidiary company is calculated. As the reserves belong to equity shareholders so the minority’s share of each reserve depends on the percentage of ordinary shares held by the outsiders. The minority interest is calculated by adding up the amounts of share capital and reserves attributable to the outsiders.[5]

But in the simple illustration above the holdings of both the parent energy company (powergen) on the subsidiaries, EDF and innogy would be: -

 Holding in EDF                         in                      Innogy Ltd

Powergen         80%                             powergen = 80% X 60% = 48 %

Minority           20%                             Minority

                        100%                           Direct                           40%

                                                            Indirect (20% X 60%) 12%

                                                                                                52%

                                                                                                100%

The effective interest of powergen in innogy is 60%. The last form of structure of a group is mixed structures. This is where a parent company owns a controlling interest in atleast one subsidiary. In addition the parent company and the subsidiary together own controlling interest in another company.

This structure can be illustrated as follows:

The holdings in the above structure may be computed as follows: -

 In EDF

Powergen                     80%

Minority                       20%

                                    100%

 

In Innogy

Powergen

§         Directly               40%

§         Indirectly 24%

(80% X 30%)          

                                 64%

 

 

Minority

§         Directly               30% 100% - (40% + 30%)

§         Indirectly             6%

(20% X 30%)

                                 36%

                                 100%

 

 

Even though the arithmetic interest of powergen in innogy is 64%, the effective interest is actually 70%. An arithmetic interest that is more than 50% does not necessarily imply control.

 

A merger is simple a combination of two or more firms to form a single firm. Like in the UK electricity industry, many are companies that have merged in the recent past. An example is the merger between RWE and VEW in April 2000. The merger resulted in the two companies almost dominating the market with duopolistic effects. Now the two companies have a market share of 70% of the electricity industry in Germany. It is a business combination in which the shareholders of the combining enterprise combine control over, the whole, or effectively the whole of their net assets and operations to achieve a continuing mutual sharing in the risks and benefits attached to the combined entity such that neither party can be identified as the acquirer.[6]

The UK electricity industry is an industry that is faced by the threat of new entrants to the industry. The number of electricity generating firms stand at around 15. In 1990, there were about three of them. This has the risk of the price of electricity declining due to competition. To combat this, two or more companies may unite their interest (merge) with the sole aim of increasing their market power (share). By doing this, more efforts can then be directed towards the customer rather than fighting the competitor. An example was RWE and VEW that merged and improved their market share to 70%.[7]

The shareholders of the combining enterprises join a substantially equal arrangement to share control over the whole or effectively the whole of their net assets and operations. In addition the management of the combining enterprises participates in the management of the combined entity. A mutual sharing of risks and benefits is usually not possible without substantially equal exchange of voting common share between the combining enterprises. Such an exchange ensures that the relative ownership interests of the combing enterprises are preserved.

 1.1 TECHNO – INDUSTRIAL DRIVERS FOR ACQUISITIONS AND MERGERS IN THE UK ELECTRICITY INDUSTRY 

One of the main drivers that have pushed the UK electricity companies into merging is because of its associated synergestic effects. Synergy refers to the economic (benefits) realized whereby the benefits of the combined firms are higher than that of its previously separate firms. Synergy brings about operating economies. This results from the benefits due to large scale operations. This may result from better efficiency in management in marketing, production and distribution. As a result of merging, the cost of transmitting electricity would likely reduce, as each company in the merger will only be responsible in supplying electricity in its location and environs only. Synergy also leads to financial economies. These include a lower cost of capital (especially debt), a greater debt carrying capacity and a higher price-earning ratio. When RWE merged with VEW in 2000, certain synergestic effects were evident. These were in Waste Management and also in the cross retailing of gas as well as energy. The other synergestic effect of merging is that of differential management efficiency? This results when one firm is relatively inefficient and the merger improves managerial efficiency as well as profitability. For instance, the British Energy (nuclear) may be having an efficient management thus making it the number one electricity company in the UK.[8]

            In the year 2005 its production capacity was approximately 9.6 Giggawatts compared to Scottish and Southern which produced a paltry 5.3 G.W. This can compel Scottish and Southern to initiate a merger with the British energy to benefit form its efficient management.

            Another driver related to acquisition is Tax consideration. Highly profitable electricity firms, which pay high corporate taxes, acquire other companies with large accumulated tax losses that can be turned into immediate tax savings. A merger can also provide an outlet for excess cash without immediate tax considerations.

            Thirdly, mergers can be driven by the fact that a company may be incurring higher costs in replacing its assets compared to the market value. To reduce such costs, a merge is necessitated.

Apart from the threat of many other firms joining the energy industry, individual companies are also faced with the threat of hostile takeover by other companies. This has necessitated some firms to merge with others to lessen the dangers of being forcefully taken over. These merges are referred to as defensive mergers and are aimed at making the company less vulnerable to a takeover. Managers involved normally argue that synergy rather than their own personal interests motivated the merger. However many of such mergers are being designed to benefit the managers rather than the shareholders. [9]

            Some mergers are also driven by the managers’ personal reasons. Many mergers in the sector have been motivated by the manager’s own reasons for example to increase their remunerations power. They are also interested in increasing their retirement packages. This is called golden parachute merges. Manager’s personal reasons constitute an agency conflict if the merger benefits the managers rather than the shareholders.

 1.2 THE FININCIAL ISSUES ASSOCIATED WITH ACQUISITIONS

 

The first financial effect associated with acquisitions is the change in the preparation of financial statements. The group would now prepare its accounts on a consolidation basis i.e. a consolidated profit and loss account and a consolidated balance sheet. For example (RWE) acquired Innogys in 2002.During the same year, the company acquired Transgas. As from that year (2002) the group will be preparing consolidated financial statements. Another issue is whether the company acquired is a subsidiary or an associate. Innogy and transgas are subsidiaries of RWE because RWE acquired more than 50% of their shares. Goodwill arising from an acquisition must be calculated. Comparing the price at which RWE purchased the subsidiaries and the nominal value of their shares. This is possible by preparing a cost of control account also referred to as a capital reserve.

            Acquisitions require very huge initial cash outlays. When RWE was acquiring the subsidiaries it spent billions of dollars for the purchase. Acquisitions have led to expansion of customer base in addition to the production of more energy. This was evident when shanks’ UK landfill was acquired in 2003. Its combination with waste recycling group led to the saving of operational costs. It also pushed the group to the top as one of the highest energy producing company in Europe. [10]

            Consequently when an electricity firm is deemed as not well performing, the Par lent Company can decide to dispose it. It can also be as a result of pursuing waste disposal contracts. This was the case when shanks wanted to dispose UK landfill in 2004. However any disposal must get the approval of the shareholders. The financial issue related to disposal of subsidiaries is on how to consolidate the disposal in the final accounts. What is more important is the percentage so disposed and date of disposal.[11]

Like disposals, it is also important to note the date a company was acquired and the percentage of acquisition and whether the acquisition gave rise to a subsidiary or associate. It is worth interesting that the position of a single entity can change from that of associates to subsidiary and vice-versa. For instance RWE acquired 75% of tapada in December 2000. This led to an increase of the percentage holding from 25%. The financial implication here is that W.e.f December 2000; RWE should prepare the accounts of Tapada as by the regulations governing subsidiaries and not associates. The consolidation must incorporate the minority interest of 25% (100%-75% in the shares of Tapada. It must be noted that minority interest in the profits and other reserves in the subsidiary is based on the profits as at the end of the accounting period. But the interest of the members of the group is based on the date that the company acquired the subsidiary. This is because, this was the date Tapada became a member of the group. A distinction should also be made between pre-and post acquisition profits. It is only the pre-acquisition profits that the holding company is entitled to.

            The treatments of dividends pose a great problem when dealing with acquisitions. Dividends may be received by a holding company from its subsidiary company out of the pre-acquisitions profits or post acquisitions profits. This does not pose any financial problem. A financial problem arises of the dividends came from pre-acquisition profits. If this is the case, they are credited to investment in shares of the subsidiariary Account thereby reducing the cost of control or increasing capital reserve. If the dividends declared are partly of pre-acquisition and post acquisition profits then the dividend received is divided into two parts in proportion to its declaration out of pre-acquisition and post- acquisition profits. The dividends relating to pre-acquisition profits is credited to investments account but the dividends relating to the post acquisition profits is credited to profit and loss Account. [12]

  1.3 THE ETHICAL AND CULTURAL ISSUES ASSOCIATED WITH ACQUISITIONS.

A company may acquire another company in either the same country or from another foreign country. As much as there can be a difference in ethics and culture in another country the same exists within a given country. These ethical and cultural issues if not combated, may negatively affect the performance of the group of companies.

Companies coming from two different regions would obviously the faced with language problems. Take for instance the acquisition of transgas by RWE. Transgas is based in the republic of Czech. These are two different nations with different languages.

Another cultural issue associated with acquisitions is the attitudes of the members of both the investor company and the acquired company. This can either be positive i.e. where the members value each other’s positions and roles or negative where members undermine each other’s significance in the group.

There is also differences in the way processing of information is done. Whereas one electricity company has been practicing a centralized information processing system, the other may be decentralizing this function. Companies from different nations may be observing different national holidays and how this will be reconciled after an acquisition is another cultural issue. It may also be the culture of one company that shareholders have to get high returns on their investment with or without profits. The other company’s focus would be on divestments retaining as much profits as possible.

Ethical issues associated with acquisitions are issues like competition. The two firms may be former competitors now joining forces and forgetting their rivalry. It would be quite interesting to see how the two former rivals would now be working together for a common objective.

There is also the issue of down sizing after an acquisition. The group may reduce its workforce for operational efficiency. They have to do this professionally to avoid confronting the legal issues and labour laws the wrong way.

After an acquisition has taken place, many changes follow and the group starts doing things in a different way. This may be in processing of electricity, marketing, recruitment and selection, to name just but a few. In adapting the above changes, the group must consider doing them ethically and professionally in a manner not likely to injure /harm other companies in the sector. They have to have a fair play as this would also safeguard them from unnecessary legal tussles.

Differences in both ethics are and the culture of two different companies can affect their performance after a merger. Reconciling these differences then by both management is inevitable. [13]

 1.4 THE OPPORTUNITIES AND BENEFITS OF ACQUISTION

The acquisitions arising in the electricity industry in the UK have given the acquirers a competitive edge over the other power producing companies. When Louisville Gas and Electric (LG&E) acquired the UK energy in 1998, the demand for its electricity rose suddenly to more than 350,000 customers. The electricity market in the UK is a very liberalized market. The price elasticity in the electricity industry triggers a more than proportionate demand, Because acquisitions lead to a reduction in operating costs, costs of equipments, reduced labour costs, etc, LG& E was able to reduce the price of electricity and be able to operate profitably. The end result was an increase in demand hence high sales turnover of electricity. For instance after acquiring the UK energy was able to serve more than 300,000 customers with natural gas. It can therefore be summarized that an acquisition offers the enterprises an opportunity to capitalize on the responsiveness of their customers to prices changes which are direct consequence of acquisitions (and mergers).

Acquisitions offer the companies a good opportunity to make use of technology in the market. The electricity industry is one that requires a lot of technological techniques in its manufacture. 3.7% of the UK energy is produced from nuclear and about 5% is as a result of renewable energy. An electricity firm can acquire another in order to take advantage of its diversified technology in the production of electricity.

Another benefit arising from acquisitions is that the combined entities would have a stronger market power/ share. The result? – More investors in the company which shall be the Linchpin for the growth of the company.

Internal growth is a slow process of growth. Internal growth may deplete a company’s resources and even affect its liquidity position; owing to the massive resources that would be required. If an electricity company  intends to place reliance on internal growth as opposed to external like acquisitions, chances are that it might be overtaken by those companies which have embraced acquisitions as a form of growth. Internal growth is also barred from becoming a success due to an agency of conflict inherent in the management. Management may undertake projects which are only profitable in the short – run to benefit from them only during their period in office. A single firm may also not be having a well competent staff to push through the growth process. But acquisitions.

Inject new management into the team that would steer growth of the group company. Together with other related benefits such as reduced operating costs and other economies of scale associated with acquisitions, the process of growth is enhanced compared to internal growth.[14]

 

1.5 POST- ACQUISITION PROBLEMS THAT TEND TO PREVENT EXPECTED BENEFITS BEING ACHIEVED.

One of the problems encountered by most UK firms after an acquisition is incompatibility of the investor company and the investee (acquiree). And this incompatibility is from many areas of perspective. The policies, rules and procedures governing the new enterprise are different and reconciling them often meets resistance especially from the members of staff. As one company can view a given area of social responsibility as beneficial to the organization, another would see it as a cost to the group. For instance, when Powergen purchased Midlands Electricity in October 2003, one of the aims of the group was to satisfy the demand of the customers. It even provided customers with social services like telecommunication. This decision was met with rage and dissatisfaction from the staff of Midlands who viewed the plan as an unnecessary cost to the organization. The acquired company also suffers as a result of policies that are imposed on it by the acquirer. These range from – adapting of certain specific processing methods and production techniques, being forced to acquire additional electricity firms, etc. For instance, when RWE acquired Innogy in 2002, it also acquired Transgas in the same period. They did this without a full consent of the management allied to innogy p/c.

Another post – acquisition problem is that of little or no co-operation at all between the acquirer and the acquired company. Mostly, the management of the investor company tends to intimidate those of the acquired company in among other areas, the decision – making process. The two firms also suffer from the changes that are usually accompanied with acquisitions: These are organizational structure adjustments, changes to rules, policies, regulations and procedures. After an acquisition, the top management teams has to change with people losing their previous top positions, employees need to be retrained on new production methods and the marketers have to change  to other new marketing methods. All these changes normally take a considerable time to be embraced and performance during such a transition period is likely to decline.

With an acquisition, there is also the danger that the acquired company may be having certain pending legal suits. The presence of these suits would neutralize the benefits that could be derived from an acquisition. For instance, the electricity industry in the UK is an industry surrounded with strict European rules especially regarding environmental issues. Many companies find themselves in difficult legal tussles after an acquisition has taken place. Instead of the planned acquisition becoming progressive, it infact becomes a retrogressive exercise.[15]

  CONCLUSION

Mergers and acquisitions have resulted in economies of scale and synergestic effects for the UK electricity companies. Increased market share, greater performance in the stock market and customer satisfaction are just but some of the benefits of such combinations. However challenges are also associated with mergers and acquisitions in the UK electricity industry. For instance when RWE merged with VEW in April 2000 the benefit was domination of the market and other synergestic effects like in waste management. However the merger led to more than 3000 jobs being lost. The firms should also focus on the importance of ethical and cultural fits between them as this may either make the acquisition/ merger successful or a complete failure. 

 REFERENCES:

Department of Trade and Industry, Government of UK (http://www.dti.gov.uk)

 De Oliveira, Ricardo Gorini and Mauricio Timono Tolmasquim (2004): ‘Regulatory Performance Analysis Case Study: Britain’s Electricity Industry’, Energy Policy, Vol 32, No 11, pp 1261-76

 Dubash Navroz and Singh Daljit (2005) ‘Of Rocks and Hard Places: A Critical Overview of Recent Global Experience with Electricity Restructuring’, Economic and Political Weekly, Vol XL No 50, December 10-16,

 Ernst & Young Report on Electricity Market to the Department of Trade and Industry, UK (http://www.dti.gov.uk/files/file28401.pdf)

 Newbery, David M and Michael G Pollitt (1997): ‘The Restructuring and Privatization of the UK Electricity Supply-Was it Worth It?’ Public Policy for the Private Sector, No 124, World Bank

 Porter, Michael: Competitive Strategy, retrieved on 29th April, available at www.en.wikipedia.org

 Thomas Stephen (2005) ‘British Experience of Electricity Liberalization: A Model for India? Economic and Political Weekly, Vol XL No 50, December 10-16, 2005.

 [1] http://www.dti.gov.uk

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