Global investment patterns in the electricity industry

© Utility Consultants Ltd 2003

Prepared by Utility Consultants Ltd

www.utilityconsultants.co.nz

Disclaimer

This research report is ofa general nature, and is not intended

as specific professional advice. Accordingly, neither Utility Consultants, nor its’ directors and

shareholders, shall be liable for any lossor damage arising from action

or inaction based on thisresearch report.

Also, because the globalelectricity industry is unfolding rapidly, theinformation herein may date rapidly. It is,

however, correct at the time of writing(mid-March 2003)

Contents

Introduction

Summaryof waves to

date Analysisof global trends

& drivers

Shaping theinvestment

climate

Analysis ofpossible

investmentsAnalysis ofcorresponding

investmentclimates

Conclusions

Introduction

Investment in utilitiesover the last 15 years or so

has fallen into 4 broad patternswhich we have referred to as

Waves

This report examinesthe four Waves that have

occurred to date, analyses thedrivers of global investment,and makes some projections

of future investments

Summary ofwaves to date

Four reasonablydistinct waves of global

investment to date

Each wave hasbeen prompted by privatisationsin reasonably distinct regions,along with some other major

utility issues

Four wavesto date are discussed in the

following pages

This chart depictsfour reasonably distinct

waves of investmentover time

Late 1980’s Early 1990’s Late 1990’s Early 2000’s

1st 2nd 3rd 4th

Time

Approx value US$b)

10

Invest

Invest

1st Wave

2nd Wave

Invest

Invest

3rd Wave

Withdraw

Withdraw

Invest

Invest

Invest

Withdraw

Withdraw

Invest

Invest

4th Wave

1st Wave

Prompted by electricityprivatisations in Argentina and

to a lesser extent in Brazil

Investorsincluded AES, Entergy, United

Utilities and EDF. Unsuccessfulbidders included CSW, LG&E

Ontario Hydro and HydroQuebec

Many of theseinvestments are now coming toa sticky end due to economicdifficulties in Latin America

Several of theseutilities were leaders ofconsortia that included

banks

2nd Wave

Prompted by electricityprivatisations in the UK followed

closely by Victoria

Investorsincluded Entergy, GPU, TXU,

Dominion Resources andUtilicorp. ScottishPower also

caught Wave #2 with theiracquisition of

MANWEB

The acquisitions ofNORWEB and SWALEC by waterutilities is noted, but they are not

significant in terms of theoverall global pattern

Most of theseinvestments were by singleutilities – no consortia or

banks were involved

3rd Wave

3rd Wave is less clear cut inthat it also involved withdrawalsuperimposed on investment

Privatisation in Europe, alongwith withdrawal of US utilities

from the UK prompted investment by European utilities such as

E.On, RWE and EdF

Complicating factorof withdrawal of investors

requires detailed examinationof their strategies to fully

understand this Wave

Withdrawalof US utilities from Victoria

provided opportunities for SEAsian utilities such as CKI and

Singapore Power to invest

4th Wave

4th Wave is also less clear cutin that it also involved withdrawal

superimposed on investment

This Wave addsinvestment in the US by

European utilities on top oftheir continued investment in

Europe coincident with USwithdrawal globally

A key feature tobe examined is why the US soquickly shifted from being a

source of investment to adestination

This investment in theUS is proceeding cautiouslyin comparison to the rapid

pace of investment inearlier waves

Wave Source of capital Destination of capital

1st

US and European utilities, several as leaders of consortia involving banks. Coincided with a re-thinking of strategy as domestic deregulation became more likely

Latin America, predominantly Argentina, but also Brazil and Chile to a lesser extent. Prompted by privatisations in these countries

2nd

Comprised almost solely US utilities (in contrast to the First Wave) acting on their own behalf rather than as consortia. Two exceptions were the acquisitions of MANWEB, NORWEB and SWALEC

UK, closely followed by Victoria, as their electricity industries were privatised

3rd

European utilities such as E.On, RWE and EdF investing in Europe, and the emergence of SE Asian investment in Australia as several 2nd Wave investors withdrew

Europe as the early privatisations began, and Australia as a “follow on” wave emerged as US utilities withdrew

4thCash-rich European utilities such as E.On. Presence of SE Asian utilities is not apparent as it was in the 3rd Wave

Europe as privatisation spreads eastwards, and the US as strong utilities are acquired

Four verydistinct strategies behind theinvestments and withdrawals

of each wave

Attempts to explaineach Wave in terms of a

simple investment strategy ofseeking a return greater thanWACC falls short of a robust

explanation

Following pagesoutline four global investmentstrategies and when they have

been adopted

Positional

Finding a niche inan emerging or reshapingmarket, often involves abank or similar to limit

risk exposure

Learning about anemerging or reshaping market

in anticipation of domesticmarkets deregulating

Making a betterreturn on WACC than is

currently available. May alsoinvolve exploiting

regulatory lag

Acquiring adjacentvalue chains to significantlyreshape an industry such as

merging electricity & gas

Investigative

Traditional

Transformational

Wave Positional Investigative Traditional Transformational

1st √ √

2nd √ √ √

3rd √ √ √

4th √ √

Next few pagesexamine the prevailing drivers

of each Wave, along with amodel that outlines key

investment issues

Model starts fromthe premise that privatisationcreates the initial investmentopportunity but other factors

determine the success &tenure of investment

These other factorsare both internal and external

to the investing utility

Privatisationcreates initial

investmentopportunity

External drivers•Political stability & risk•Economic drivers•Regulatory risk•Social cohesion

Internal drivers•Strategic posture•Risk profile•ROI hurdle•Balance sheet size & strength

These issues determine ability to make initial

investment and then to retain investment

1st Wave

Privatisationin Argentina (and a few other

countries) created theopportunities

Impending deregulation inUS & Europe (although it was

still a few years away, thesharper utilities did correctly

recognise it coming)

Lack of globalInvestment experience,particularly in correctly

identifying politicalrisks

Accumulatedcash reserves

2nd Wave

Privatisation inUK and in Victoria

created opportunities

Rapid maturingof thinking, particularly with

Investment risk

Coincident privatisationof gas distribution & supply in

Victoria provided the opportunityto develop transformational

strategies

Recognition that thesemarkets could be similar to

those likely to emerge inthe US

3rd Wave

Privatisations in Europecreated investment

opportunities

Withdrawalof early-mover US utilities

such as Entergy

Cash-rich positionof several SE Asian utilities,

combined with their recognitionof eventual deregulation in

their domestic markets

Emergence of politicalrisk in Western countries (UK

wind-fall tax) and regulatory riskin the UK water sector

4th Wave

Privatisation inEastern Europe creates

investment opportunities

Regulatory constraintsforce large utilities like E.On

to divest non-core assets,strengthening their cash

positions

Over-exposure to tradingrisk and under capitalisation of

many US utilities led to their exit,prompted significantly but not

totally by Enron’s collapse

Further regulatory risksemerge such as the electricity& gas price controls in Victoria

and the Epic Energy tariffdispute in Western

Australia

Also importantto consider the valueof acquisitions within

each wave

Most 1st and 2nd,

Wave acquisitions werevalued between about US$600mand US$1b (at the time of writing

the US$ and the € are aboutequal and are usedinterchangeably)

As the 3rd and 4th Wavesemerged, acquisition valuesclimbed noticeably into the

order of US$3b to US$5b

E.On’s recentacquisition of Ruhr Gas for

€10b altered the dynamics ofglobal acquisitions, suggesting

that only the largest utilitieswill continue to play

The possibleprivatisations of EdF and

GdF for prices in the order of€100b may further alter this

dynamic another orderof magnitude

A key factor inthis appears to be the depth

of acquisition that has occurredcoinciding with the huge warchests amassed by utilities

like E.On, Vivendi andSuez

One hypothesisis that future Waves couldcomprise one or two very

large acquisitions – we willtest this hypothesis in

later sections

However thetiming, source and destinationof the Ruhr Gas and proposed

Iberdrola acquisitionssuggests a continuation

of the 4th Wave

We will examinepossibilities for the 5th andsubsequent Waves in later

sections

Analysis of globaltrends & drivers

This sectionidentifies the drivers, issues

and risks that the globalelectricity industry faces

These issuesbroadly fall into 7 groups or

clusters, although some issuescould fall into more than 1cluster and may conflictwith other issues in the

same cluster

Clusters aredepicted as clouds to emphasise

fuzzy, shifting boundaries

Industry & market events

&features

Industry & market events

&features

Primary energy supply, natural

resources & environment

Primary energy supply, natural

resources & environment

Regional economy

Regional economy

Societal advancement &

cohesion

Societal advancement &

cohesion

Public opinion & policy

Public opinion & policyNational &

regional regulatory & competition

National & regional

regulatory & competition

National & regional political position

National & regional political position

Primary energy supply, natural

resources & environment

Primary energy supply, natural

resources & environment

Shift towardsgas-fired generation asnew reserves emerge

Shift towardsgas-fired generation to

drive down costsShift towards

gas-fired generation toreduce emissions

Shift towardsgas-fired generation asnuclear generation is

closed to meet EUentry criteria

Renewed interestin coal as clean-coaltechnologies emerge

or as gas reservesdwindle

Ambivalence towardclimate change initiatives

by major nations

Continued issueof disposal of spent

nuclear fuel

Expected shift togas-fired generation maybeconstrained by dwindling

reserves or accessto corridors

National & regional political position

National & regional political position

Certainty ofaccess to gas

transmission corridors,particularly in Eastern

Europe

Increasingwillingness of

governments to intervenewhen prices spike

Risk ofnationalisation hasbecome very real in

certain countries

Increased potentialfor political fall-out to

disrupt delicatelybalanced energy

markets

Continued likelihoodof electricity being a

political football

Public opinion & policy

Public opinion & policy

Increasingpublic opposition tonuclear generation

Continuedunlikelihood of coherent

long-term energypolicies in most

countries

Emerging trend ofincreasing policy lurchesin response to short-term

shifts in publicopinion

Increasingpublic opposition to

privatisation

Increasingpublic opposition to

regionalisation &globalisation

National & regional

regulatory & competition

National & regional

regulatory & competition

Slowing butdefinite move toward

ring-fencing linesand energy

Slowing ofring-fencing of supply

from generation

Price control riskis well established – no longer a remote

possibility

Increasingregulatory constraints as

multiple jurisdictionsbecome involved

Continuedtension between utilities

and regulators overmarket definition

Increasedsurveillance of financial

processes

Industry & market events

&features

Industry & market events

&features

Reality of high costof nuclear generation

as closures occur

Global shifttoward more conservative

risk profiles andcapital structure

Increasingdemand as economies

shift in developingnations

Many largeutilities now face market

dominance limits

Increasingdemand as market

economies gaintraction

Abruptchange in financial

fortunes of historicallystrong US utilities

Decliningability to recoverstranded costs

Societal advancement &

cohesion

Societal advancement &

cohesion

Status as anagricultural, industrial,service or knowledge

economy

Generallevel of order& discipline

Whether order &discipline is enforced bystrong individual values

or by centralisedauthority

Access todue process

Degreeof transparency and

corruption

Regional economy

Regional economy

Vulnerability ofmany economies to

single issues orindustries

Recentdevaluation of

LatAm currencies

Certainty oftaxation including“wind fall” taxes

Reconstructionrequiring investment in

regions of high risk

Environmentalpressure constrainingeconomic growth in

developing countries

Shaping theinvestment climate

We now examinehow these issues, risks &drivers shape investmentopportunities & climates

Critical to distinguishbetween the issues that create

investment opportunities and theissues that create favorable

investment climates

Following table isderived from a matrix thatscores each investment

destination out of a total of 320points based on 32 key

issues

Key issues, drivers & risks

1st Wave 2nd Wave 3rd Wave 4th Wave

Latin America

Victoria UKWestern Europe

Victoria & SA

US UK

National & regional political positions (score 60)

28 49 51 46 46 52 40

Public opinion & policy (score 40) 19 27 31 20 25 33 26

Regulatory & competition (score 50)

39 37 39 31 32 30 28

Industry & market features (score 40)

29 33 31 25 29 28 25

Societal advancement & cohesion (score 50)

17 43 43 30 42 42 40

Regional economy (score 50) 38 42 42 38 39 41 32

Primary energy, natural resources & environment (score 30)

25 22 20 18 20 26 17

Total score (score 320) 195 253 257 208 233 252 208

Key drivers of thisdecline in the UK were the

increased risk of tough pricecontrol, increased market risk,electricity becoming a political

football and the windfalltax

Observations fromthe previous table are that

investment attractiveness inboth the UK and Victoriahas declined over time

Key drivers of thisdecline in Victoria were the

increased risk of tough pricecontrol and increased

market risk

Latin America’sscore drops 31 points

when re-assessed to the presentbased on currency instability

and tough price controls

Analysis ofpossible investment

opportunities

The followingmaterial is speculative in nature

in that the emerging opportunitiesand investment climate drivers

are not yet clear

Following mapoutlines 10 regions that

will be examined

Six blue regions(A thru’ F) have eithernot yet privatised theirelectricity or are at the

early stages

Four red regions(G thru’ J) have already

privatised, but could be subjectto further exit/entry

processes

Possibledestinations

for investment

A

B C

D

E

F

G

I

H

J

Six blueregions (A thru’ F)

Africa

Russia

Canada

China

SE Asia

Central Asia

Four red regions(G thru’ J)

US

Latin America

Australia& New Zealand

Europe

Region Opportunities / remarks Expected value

Africa

•Continual progress toward privatisation in smaller countries such as Zambia and Tanzania – how successful they will be in the midst of political unrest and low social cohesion remains to be seen•Most significant opportunity is the proposed sale of 30% of Eskom’s generation capacity, of which 20% will be to the public

•Based on replacement cost of generation assets, the 30% stake could be worth between US$4b and US$6b

Russia (UES)

•Disaggregation of UES and sale of the Federal Grid Company (transmission grid) – date not clear, but likely to be within the next year or so

•Market cap in mid-March 2003 is US$5.77b.

Canada

•Hydro-Quebec very unlikely to be sold•Hydro One (Ontario) very unlikely to be sold•Break up and privatisation of BC Hydro was mooted in late 2002, but would seem unlikely•Other provinces also generally seem against any form of deregulation or privatisation mainly due to very low prices.•Recent political intervention in Ontario is likely to discourage private sector interest, although strong pressure from US utilities wanting access to Canadian electricity could over-ride this

Region Opportunities / remarks Expected value

China

•State Power Corp breakup details finalised in late 2002•Likely that generation assets will be allocated amongst 5 pre-existing companies and that T&D assets are likely to be split into a Southern and a Northern company•State Electricity Regulatory Commission formed as part of the breakup•Some companies already seeking foreign investment, but only of the order of 1% of total industry value

•Total value of State Power Corp estimated at US$144b

SE Asia

•Reform and privatisation well underway in Singapore•Privatisation just starting in South Korea and Philippines (Philippine government is already expecting bids for Transco to be heavily discounted)•Move toward diminishing government funding in Indonesia, allowing PLN to raise private debt•PNG privatisation halted

•Philippines Transco indicatively valued at US$2b, but may be heavily discounted

Region Opportunities / remarks Expected value

Central Asia

•Reform and privatisation underway in India•Break up of Sri Lanka’s CEB should be complete by end of 2004

US•Listed capital provides obvious acquisition paths to most utilities, but recent interest of European utilities such as E.On and RWE has cooled.

Latin America

•Opportunities are arising from various exits, but circumstances surrounding these exits make for very unattractive investments, particularly currency devaluations in Argentina.

Australia & New

Zealand

•Present political climate in both Australia and New Zealand is unlikely to attract global investment.•Recent regulatory determinations and trends may make it difficult to retain existing capital

Europe

•Current Gas Natural bid for Iberdrola•Anticipated privatisation of EdF and GdF•EnBW’s proposed IPO possibly in 2004•On-going deals arising from merger concessions of big deals such as Ruhrgas and Iberdrola, and from privatisation programs

•€14b•US$100b

Analysis ofcorresponding investment

climates

Following table scoreseach investment destination

out of a total of 320 points basedon 32 key issues as defined

previously

Destinationspreviously analysed haveshown a marked drop inattractiveness (analysed

in subsequent pages)

Key issues, drivers & risks

Africa Russia Canada ChinaSE

AsiaCentral

AsiaUS

LatAm

Aus & NZ

Europe

National & regional political positions (score 60)

18 39 23 31 25 22 48 15 27 27

Public opinion & policy (score 40)

18 26 17 30 21 20 30 15 10 11

Regulatory & competition (score 50)

32 32 23 30 25 25 21 21 21 24

Industry & market features (score 40)

27 26 20 29 23 27 18 24 26 18

Societal advancement & cohesion (score 50)

8 21 43 16 14 13 42 18 41 28

Regional economy (score 50)

24 36 37 36 32 33 37 21 28 30

Primary energy, natural resources & environment (score 30)

18 25 17 24 24 26 23 21 15 22

Total score (score 320)

145 205 180 196 164 166 219 135 168 160

Destination1st Wave

score

2nd Wave

score

3rd Wave

score

4th Wave

scoreProjected

scoreKey reasons for

score movement

LatAm 195 135

•Increased likelihood of political intervention•Decreased currency stability

US 252 219•Increased market risk•Slight increase in regulatory intervention

Victoria 253 233168 (incl.

NZ)

•Increased likelihood of political intervention•Increased public opposition to globalisation etc•Significant tightening in regulatory trends•Decline in underlying economic attractiveness

UK 257 208160 (incl. Europe)

•Increased likelihood of political intervention•Increased public opposition to globalisation etc•Significant tightening in regulatory trends

Projectingpossible future

waves

The followingmaterial is speculative in nature

in that the emerging opportunitiesand investment climate drivers

are not yet totally clear

This section rollstogether the analysis to dateinto a high level that should

reveal possible futureinvestment patterns

Followingcharts suggest that mostopportunities are likely to

occur In the immediatefuture

Unpredictableinvestments such as Gas

Natural’s unsolicited offer forIberdrola can complicate

this analysis becauseof their size

DestinationLikely size of investment opportunities emerging

Likely timingAttractiveness of

investment climate

Africa

•Eskom likely to sell30% of generation, 20% will be to the public – possible value US$4b – US$6b

•Possibly over next 2 years

•Poor

Russia

•Sale of UES likely to start with sale of Federal Grid Co. – possible value of FGC about US$360m (total value may be US$6b)

•Possibly within the next year

•Good

Canada•Opportunities unlikely, lease of all from Ontario and Quebec

•Average

China

•Some foreign investment to about 1% of industry’s value – not clear if full privatisation will proceed (possible value US$144b)•Bond market is likely to open up as State Power Grid spends aboutUS$5.3b over the next few years

•Good

DestinationLikely size of investment opportunities emerging

Likely timingAttractiveness of

investment climate

SE Asia

•Philippines and South Korea – likely to be heavily discounted because of perceived risks

•Any time now •Average

Central Asia•India and Sri Lanka - opportunities appear minor compared to others

Already in progress

•Average

US •No obvious opportunities •Good

LatAm•Investor exit creating opportunities, but these are unattractive

•Poor

Aus & NZ •No obvious opportunities •Average

Europe

•Several major deals appear close such as Gas Natural’s bid Iberdrola and the possible privatisation of EdF and GdF•Regulatory concessions from big deals are likely to prompt smaller deals

•Any time now •Average

Following tablesuggests that the most

obvious investment is likely tobe in Europe, but broadlycontinuing the 4th Wave,

confirming ourhypothesis

It is acknowledgedthat the Ruhrgas and Iberdrola

acquisitions are large enough toconstitute their own Wave, but

happen to coincide withthe 4th Wave

The proposedEdF and GdF privatisations

will almost certainly constitutetheir own Waves

Timing Description & value of transactionDoes it fit the 4th Wave ??

Now – 6 month

•E.On’s acquisition of Ruhrgas (€10b) Yes

•Gas Natural’s proposed acquisition of Iberdrola (€14b) Yes

•Privatisations in Philippines & South Korea (no precise details available)

No

6 – 12 month •Privatisation of UES (possibly US$6b) Yes

12 – 24 months

•Privatisation of 30% of Eskom’s generation capacity, 20% available to the public (US$4b – US$6b)

No

•China’s State Power Grid is likely to be spending about US$5.3b, and will be issuing bonds

No

24 months - •No obvious deals

Unclear•Possible privatisation of EdF and GdF (about €100b) – precise timeframe not available.

Yes

Following chartextends the chart presented

under “Summary of Waves todate” based on our analysis

Conclusions arenot particularly exciting, but

that’s what the analysishas revealed

Note thatinvestment in the State PowerGrid (China) Is likely to be debt

via a bond issue rather thanequity

This chart depictsthe expected Waves

Now – Sep 03 Sep 03 – Mar 04 Mar 04 – Mar 05 Unclear

Ruhrgas

Time

Approx value US$b)

10

Iberdrola

UES Eskom

China SPG

(Bonds)

EdF & GdF

(Not to scale)

Continuation of 4th Wave Distinct future Waves Wave all of its’ own

Conclusions

Our analysisleads to the following

conclusions…

Opportunitiesprompted by privatisations maybecome fewer as political and

energy policies re-shape, manyin response to perceived

“market failures”

Investmentclimates are becoming less

attractive as price control, marketrisks and political risks

emerge

Unwillingness toprivatise and the unattractive

investment climate may prompta rise in debt funding

and tothe following

conclusions …

Mergerconcessions associated with

the really big deals are likely toprompt a flurry of smaller deals

in the €500m range

Many of these biggerdeals are likely to be fundedfrom sale proceeds (requiredas merger concessions) or

by share swaps

Future Wavesmay be characterised more by

coincident timing rather than byany common geographical

component

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