Revisiting European utility portfolios

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The European utility industry is in the midst of a significant upheaval. Enticed by the opportunity to capitalize on the Continent’s move toward a greener future, disruptive competitors are entering the utility market with new capabilities and strategies. Some new entrants, such as oil and gas majors, are used to large capital projects similar to huge offshore wind parks. Others, such as infrastructure investors, have better access to capital compared with utility incumbents, enabling bold investments in renewable generation or grids.

Additionally, new entrants such as large digital players feature distinctive technological capabilities and customer access, providing them with an edge against retail incumbents. Newly entering digital attackers with end-to-end digitized business models and modern IT platforms can, for instance, take over significant market shares from incumbents by leveraging significantly lower cost bases and acting more agile. Others bring specific skill sets or capabilities not available to incumbents that enable them to get a foothold in new downstream activities, such as a focus on energy efficiency and data solutions.

Utility incumbents need to respond at pace, find the right value-chain positioning, and build a winning portfolio strategy. However, “simple truths” often don’t hold—rather, a more nuanced answer is required. At the same time, the upside of “getting it right” has increased consistently. The difference between high and low performers as measured by the standard deviations of earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples of integrated utilities has increased from around 1.0 to 1.5 at the beginning of the decade to 2.5 to 4.5 in recent years. Similar trends can be observed for specialized companies.

Thus, for incumbents and disrupters alike to be successful in adapting their portfolios for a greener and more competitive world, they must find the right strategy—but it won’t be one size fits all. In addition to overcoming common strategic myths, companies will need to make strategic moves. The moves they make depend on their unique exposure to different value-chain segments and stakeholder structure, ranging from:

  • “surfing the wave,” focusing on reallocating resources to the biggest or high-growth segments; to
  • “going against the tide,” investing in relatively smaller or low-growth value-chain segments.

For both strategic directions, either traditional or novel approaches can be taken, opening up a chessboard of player-specific moves to choose from. Our research suggests that these decisions will be heavily influenced by the company’s perspective on value pools and its current capabilities. While renewables generation and grid will continue to be the largest EBITDA value pools in the next decade, both areas are also highly competitive, with new players entering the market. Therefore, some firms, with their individual starting points and capabilities, might not be able to successfully “surf the wave,” but rather could find opportunities in “going against the tide,” such as by focusing on the comparatively smaller conventional generation or retail segments.

As market dynamics change, so must portfolio strategies

The backdrops of such strategic choices are changing market environments, with many consolidated markets fragmenting and numerous fragmented markets consolidating. Indeed, the competitive landscape in most EU utility markets is changing through consolidation and fragmentation in, for instance, generation and retail as corporate and new digital attackers enter those segments. McKinsey analysis indicates that 71 percent of major generation markets and 68 percent of major retail markets experienced either consolidation or fragmentation between 2003 and 2017.

As the tectonic plates of the utility industry continue to move in various directions, incumbents and new entrants need to revisit their portfolio strategies to maintain their market position and further strengthen growth platforms. But, before making a choice on their strategy plays, both utilities and nonutilities will need to bust four common myths.

Four myth busters that will invigorate your portfolio strategy

Historically, a set of underlying beliefs was associated with portfolio strategy discussions across the utility industry. However, these notions, such as the allure of specialization to boost performance, often cannot stand the test of a more thorough analysis. Based on a review of long-term performance across the value chain, we have identified the following four crucial myths—and busting them will help you invigorate your portfolio strategy:

  • Overperformance is rooted in specialization.
  • Programmatic M&A is the best option for utilities.
  • Legacy assets divestiture always is a winning strategy.
  • Geographical expansion is the way to go.

Based on a review of long-term performance across the value chain, we have identified four crucial myths—and busting them will help you invigorate your portfolio strategy.

Overperformance is rooted in specialization

During past years, some specialized players have consistently outperformed integrated ones by measure of total returns to shareholders (TRS), implying that specialization might be a virtue in itself. Forward-looking capital markets also tend to value specialized companies—those focusing on isolated segments of the value chain (such as distribution grid and renewables generation)—higher than integrated ones, making this strategy appear attractive. Indeed, looking at the overall numbers, specialized utilities’ TRS was approximately two percentage points higher between 2010 and 2019 than for integrated ones.

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However, our research paints a more nuanced picture: we found that a root cause of overperformance is more extensive exposure of many specialized players to attractive areas of the value chain, such as renewables and grids. Looking at the TRS (2010–19) for companies with a comparatively higher share of renewables generation shows clear overperformance (Exhibit 1). At the same time, we found significant performance discrepancies among specialized utility companies focusing on different steps in the value chain, with high TRS of those exposed to areas such as renewables and low TRS in areas such as retail. Yet it took most large integrated incumbents substantial time to invest boldly in renewables, thus missing out on some of the returns, as indicated by Exhibit 1.

Renewables are a main driver of excess TRS.

Programmatic M&A is the best option for utilities

Programmatic M&A is an often-advised strategy for companies across different sectors, among them utilities. From 2007 to 2017, when averaging data across various industries, companies implementing such an approach outperformed peers. Thus, one could assume that a programmatic strategy yields the highest returns for utilities as well. However, it does not. This conclusion holds true only for the broader energy market—for instance, players from the oil and gas or metals and mining sectors realizing such a strategy produces excess median returns of 0.9 and 4.3 percentage points, respectively (Exhibit 2). However, in utilities, companies with a programmatic M&A approach saw their median TRS 14.9 percentage points below the respective value for the full sample of firms.

Global energy and materials companies typically outperform via a programmatic M&A approach—except for EPNG.

Analyzing case studies from recent years reveals two key drivers for such underperformance. First, utilities took an opportunistic approach to drive their investment and divestment decisions. For instance, three European companies combined investments into generation capacity across renewables and conventional generation, such as nuclear, which then led to mixed returns for the respective deals.

Similarly, divestitures of assets driven by a need to generate capital failed, in the specific cases of two utility firms, to boost performance as intended. Second, other programmatic transactions in utilities suffered from poor market timing. In two cases, asset investments were followed by substantial depreciations, leading to an evaporation of TRS for those companies.

Legacy assets divestiture always is a winning strategy

Traditionally, many utilities have pursued similar divestment strategies. For example, in the last years we have seen a wave of companies selling their conventional generation assets to financial and opportunistic investors to then invest the proceeds in different areas of their business. In doing so, these investors capitalize on the short- to midterm profitability of these conventional assets while at the same time benefiting from the reduced public and environmental, social, and governance–related scrutiny they face. Similarly, the divesting companies were expected to substantially profit from the reinvestment of their proceeds into other areas of their business.

However, our research suggests that this generalization does not necessarily hold true. Rather, McKinsey analysis underlines that the decision of where to reinvest is at least as important as the divestiture itself. Looking at returns since divestiture shows that utilities reinvesting in renewables generation were substantially more successful, in some case achieving 22 percentage points in excess TRS. In contrast, incumbents that divested assets and focused exclusively on downstream activities, such as distribution and retail, saw as low as –32 percentage points in “excess” TRS since their divestitures. So for utilities that divest, there is a clear need to put the reinvestment strategy first.

Geographical expansion is the way to go

Utility companies often think of geographical expansion as a silver bullet, particularly when in a situation in which they need to compensate for or escape from poor performance in their home markets.

However, our research shows that this is seldom a winning strategy. To begin with, we see players from less attractive home markets underperform those from more attractive ones across the board (–3 percentage points TRS versus +10 percentage points TRS, respectively), regardless of their exposure to international markets. Similarly, incumbent companies in more attractive markets outperform consistently, even if their business activity mainly takes place in geographies beyond their home turf. While there are many underlying reasons for these trends, our analysis underscores the need to go beyond internationalization in utility portfolio strategy. Rather, the first priority should be to “get your house in order” and focus on the most promising segments along the value chain in your home market.

Achieving a winning portfolio strategy

The strategic options that incumbent utilities pursue heavily depend on their starting position, including their exposure to different value-chain segments and their shareholder and stakeholder structure, such as a state-owned versus privately held company. Drawing on our experience, there is a chessboard of both traditional and unconventional M&A strategic plays that utilities and nonutilities could pursue (Exhibit 3).

Based on the value-chain view, we see a chessboard of differentiated strategic plays.

Surf the wave

In this group of strategic plays, utilities are focused on reallocating resources to the biggest and fastest-growing segments of the value chain: renewables and grid. In doing so, they could take traditional approaches, such as aiming to become a top-notch renewables company or scaling transmission or distribution grids via M&A. A more unconventional approach could involve joining forces with oil major or infrastructure funds.

Top-notch renewables play: Utilities can benefit from scale and cost synergies with this approach, and also gain access to complementary geographies, technologies, and skills. This play bets on the benefits of investing in a fast-growing sector and tapping into potential from industrialization at scale—for instance, through sophisticated asset allocation and pipeline management as well as strong capabilities in auctioning processes. Possible downsides include an increase in commercial risks, such as merchant exposure, high valuations for renewable businesses, and limited availability of target businesses, which later increases competition.

Focused grid play: The core of this approach is the focus on another fast-growing sector, transmission and distribution grids. In addition to cost and scale synergies, gaining access to complementary geographies as well as the high degree of regulation and thus stable returns are upsides. As disadvantages, current high valuations, needs for extensive capital expenditure, and decreasing remuneration tendencies are to be considered.

Joint forces play: Partnering with a nonutility player, such as an investment fund or oil major, could be a true strategic booster for established companies. By tapping into additional capital at comparatively lower costs as well as a distinctive skill set and culture (for example, experience in offshore platform buildup), performance could thrive. Challenges along such a pathway would be misaligned priorities, return expectations, and different intrinsics of partnering firms.

Go against the tide

This category of strategic approaches also contains plays for companies wanting to invest in value-chain segments with limited or negative growth, such as conventional generation or retail. Traditional approaches could be gaining flexibility through conventional generation or pursuing a consolidation play in retail and new downstream. Potential unconventional approaches are an opportunistic legacy play or a digital-attacker play in retail and new downstream.

Flexibility through conventional generation: At the heart of this play is addressing the growing need for flexible generation capacity, driven by the increasing renewables penetration. With more and more players exiting conventional generation, competition is poised to decrease and opportunities will emerge. Still, remuneration for flexible assets faces uncertainty and the market itself is contracting, with antitrust concerns being a further potential roadblock to expansion strategies.

Consolidation play in retail and new downstream: This play is aimed at consolidating utilities’ existing retail and new downstream portfolios. Doing so could enable scale benefits and much-needed cost synergies, while at the same time combining complementary geographies, offerings, and skills. However, integrating legacy platforms can be expected to be challenging (for example, different IT backbones) and both competition and structural margin pressure remain high.

Opportunistic legacy play: Companies open to a more unconventional approach could aim their efforts at consolidating legacy generation assets, such as in lignite, hard coal, and nuclear. Given the market shift away from such technologies, attractive opportunities, driven by both comparatively low valuations and substantial profit generation ability of the assets themselves, exist. But such a move creates exposure to risks from tightening regulation and of reputational nature.

Digital-attacker play in retail and new downstream: Partnering with or acquiring a digital platform or attacker could provide access to strong technical capabilities. As a result, significant growth potential and increasing competitiveness through agility would drive top and bottom lines. But competition in this area of the value chain is expected to remain fierce, and both new entrants and incumbents have had difficulties in successfully establishing a truly digital platform.

COVID-19: Short-term challenge and long-term catalyst

By busting entrenched strategic myths, evaluating current capabilities, and deciding what areas of the value chain are most promising, utilities will be ready to take on their competitors and evolve alongside a dynamic market.

In the short term, COVID-19 and the associated economic effects have put the European utility sector to a stress test. Operationally, companies needed and still need to put their business-continuity planning into action and guarantee stability. At the same time, demand patterns have significantly, and at times on rather short notice, shifted. Still, the industry, with few exceptions, mastered 2020 impressively well, with incumbents’ results exceeding capital market expectations and growth ambitions invigorated for the new decade.

The COVID-19 shock has accelerated the momentum of previously ongoing industry shifts, thus amplifying the need to reexamine portfolio strategies. With the transition to a more sustainable energy system gaining steam across Europe in both the political and corporate arenas, the ground will keep moving for incumbents and new entrants.

As the European utility industry continues to focus on renewables and distribution, companies will need to establish a forward-looking strategy. By busting entrenched strategic myths, evaluating current capabilities, and deciding what areas of the value chain are most promising, utilities will be ready to take on their competitors and evolve alongside a dynamic market.

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