Electric raid sets sector humming

The regional suppliers may face a wave of mergers and integration if th e regulator takes the soft approach on competition issues, writes David Bowen

Trafalgar House's assault on Northern Electric has set the City abuzz with talk of rule-bending, and whether the whole sector is about to change hands. The financier George Soros's stake in Northern has added to the juicy speculation, as has the b ehaviour of Trafalgar's adviser, Swiss Bank Corporation, in buying 8.24 per cent of Yorkshire Electricity and lesser stakes in four other regional electricity companies (RECs).

But will these manoeuvrings have any real effect on the electricity industry? Will consumers, employees or even shareholders notice the difference?

The answer is: maybe. It depends above all on the attitude of the technocrats, and particularly the super-technocrat, Stephen Littlechild, director-general of the Office of Electricity Regulation (Offer).

If he takes a relaxed view of the competition issues, the market will take over - and we could well see a wave of takeovers and mergers. These would certainly affect employees and shareholders, though consumers would struggle to spot the difference. Dis t ribution prices are decided by the regulator, not the RECs, and they make up less than a third of the average bill. It is the price of coal and gas, not merger mania in the REC market, that will make the real difference to our meter charges.

There may, however, be subtler differences. The most intriguing development could be the emergence of integrated utility companies: the same van would service electricity, water and gas supplies, and one bill would cover them all.

Britain was the first country to privatise its electricity industry, in 1990. Ministers set the rules then, and said they could not be changed for five years. In England and Wales, the business was split between two generators, PowerGen and National Power, and 12 regional electricity companies (RECs). The RECs were the replacements for the old local boards. In Scotland, Scottish Hydro and Scottish Power were established as integrated generators and suppliers, while Northern Ireland Electricity was left out of the initial upheaval - it was not privatised until 1993 .

Unlike the generators, the RECs make most of their money from a natural monopoly. Though some have shares in gas power stations and can compete to win the business of the biggest electricity users anywhere, their bread, butter and jam comes from the power supply to homes and businesses in their regions. There is only one set of pylons and lines, and no-one is proposing to build another.

Without competition to keep prices down, the Government has had to do it. It told the RECs when they were established that they could increase their prices by 1.5 per cent above the inflation rate for five years. It also took a Golden Share in each company, to protect it against takeover, and said that no one could own more than 15 per cent of any one company.

These restrictions run out on 31 March, which is why the City is smacking its collective lips in anticipation. The Trafalgar House bid for Northern confirmed its belief that the sector would soon be shaken by takeovers.

It is possible that the bid will be referred to the Monopolies & Mergers Commission. The issue would not be competition: Trafalgar House and Northern do not compete. Rather, the Government may ask the MMC to look at the whole industry, to see how well the privatisation experiment has gone in its first half-decade, and how it should continue.

The spate of bloated profits announced by the RECs in the last months of 1994 suggests there is a strong case for casting a stern eye over the industry. Profits and dividends up by more than 20 per cent may have been good news for shareholders and the City - but customers could justifiably look askance.

Professor Littlechild looked askance, too. Last autumn he said the RECs would have to make a one-off cut of up to 14 per cent in their charges, and increase their prices by 2 per cent below the inflation rate. They would not, however, have to pay back any profits they had made in the past four years.

The Labour Party is threatening to apply a "windfall tax" to excess profits made by monopolies. But according to Peter Vass, research director of the Centre for the Study of Regulated Industries (which is partly funded by the utilities), that would be difficult to do without removing the RECs' incentive to cut costs. "If they reduce costs, that improvement goes straight to the bottom line," he says.

Whether or not there is an MMC enquiry, most analysts believe not only that outsiders will bid for RECs but that they will eventually merge with each other. "A lot of people say there will be single-figure RECs by the end of the century," says Adam Forsyth, an analyst for NatWest Markets. "There is logic in grouping some of them, to take out fixed costs - such as headquarters - and to allow them to negotiate harder with the generators."

A merger between neighbouring RECs, especially smaller ones, would make most sense. Mr Forsyth suggests that Manweb could join up with Norweb or Swalec, or Swalec with South West Electricity.

But there could be problems. The regions were not arbitrarily carved out: they were based on local networks built long ago and often with different systems. "Merging could create considerable technical problems," says Kevin Lapwood of the brokers Smith New Court.

There could also be management clashes. That is why the chief drive for mergers is likely to be as a defence from outside attack. "They will only turn to each other if a hostile bid forces them to," one analyst says.

RECs do not have to be the targets of bids, of course. Southern, one of the two biggest, has said it might act as a "white knight" if a smaller REC received an unwilling bid.

If the companies do start merging, how far would the process be allowed to go? The limit will come, Mr Vass believes, when the regulator decides he cannot afford to lose any more RECs if he is to make sensible comparisons. "I could see him allowing them to go from 12 to nine, but then he would start getting nervous," he says. "I could also imagine two RECs being allowed to merge, but only if the distribution companies, which have local monopolies, were kept as separate subsidiaries."

The industry and the City have both been pondering the sense of creating regional utilities. The idea is not new. Shortly after privatisation, Welsh Water bought 15 per cent of Swalec and suggested a merger. It was forced to sell the stake by its shareholders, who were not convinced of the logic. But analysts now view the idea with favour, while from an industry and consumer (though not employee) viewpoint, there is an attraction in having one bill and one engineer fixing both the mains and the drains. The savings would be particularly great in sparsely populated areas.

The logic would be increased further if the utility included gas. Some of the RECs are already involved in the gas market and independent companies are being encouraged to compete with British Gas in the supply market.

But the industry will not be reshaped by mergers alone. Some of the bigger RECs have been pursuing their own expansionist policies. East Midlands burnt its fingers in the process (its chief executive was forced to resign), and is now keeping a low profile. But Eastern is turning itself into a creature more akin to Scottish Power than another REC. It already has shareholdings in gas power stations and has invested in North Sea fields that will provide them with fuel. "Its aim is to be all things to all men," Mr Forsyth says.

Some RECs are moving into quite different sectors - Swalec part-owns a cable television franchise - while others are going abroad. Norweb has a stake in a heat and power plant in Virginia, the United States, while Midlands is looking at a generating project in Turkey. Both want to increase their earnings from deregulated business.

Supplying local electricity has been highly profitable and will continue to be a nice little earner. But it is not enough to satisfy the more ambitious managers: one day, we may even see an REC launching a bid to take over a conglomerate.