An Uncertain Future for Europe's Utilities

Despite big profits, shareholders are nervous about the volatile sector. An EU drive to break apart networks and the cost of going green are two concerns

Exhaust plumes from cooling towers at the Jaenschwalde lignite coal-fired power station, which is owned by Vatenfall, April 12, 2007 at Jaenschwalde, Germany Sean Gallup/Getty Images

by Mark Scott

These are golden days for European utilities. High energy prices and strong industry fundamentals, including ever-increasing demand for electricity, mean power companies across the Continent are posting record results at a time when many others are feeling the chilling effects of the credit squeeze. On Feb. 20, for instance, French giant Electricite de France (EDF.PA) announced 2007 net profits of $6.9 billion, up 10.6%. A day later, Britain's Centrica (CAN.L) reported its own 2007 net profits rose a staggering 40%, to $3.8 billion.

Yet behind the bumper results lie huge challenges that could test European utilities as never before. The quest for regional and global growth is kicking off another round of cross-border mergers just at a time when obtaining financing for big deals has gotten more expensive. Strict European environmental rules requiring 20% of energy to come from renewable sources by 2020 will require billions of investment dollars in sometimes untested new technologies. And European regulators are pushing to break big utilities into separate generation and distribution units.

All in all, tough prospects. "We're seeing a lot of jockeying between national and regional players looking for the best way to move their businesses forward," says Tariq Akbar, senior energy and utilities analyst at market researcher Datamonitor in London.

Lower Prices, Lower Profits

The most pressing risk is a drive by the European Commission to increase competition within the sector by forcing utilities to break apart. Spearheaded by fiery Competition Commissioner Neelie Kroes of the Netherlands, the plan would require companies like Gaz de France (GAZ.PA) to give up control of profitable distribution networks used to transport energy across the Continent.

The goal is to level the playing field and make it easier for new entrants to take on incumbents such as GDF and Germany's E.ON (EONG.DE). Analysts figure structural separation will help bring down end-user prices by letting new firms compete with former state-owned monopolies. But for the incumbents, lower prices likely will mean lower profits as well.

The proposals from Brussels have been met with staunch opposition from France and Germany. Both countries appear more interested in protecting national champions than in opening up their domestic markets to competition. Yet despite the objections, Brussels announced legislative proposals on Jan. 23 that could lead to the separation of European utilities.

Expensive Environmental Initiatives

According to David Buchan, senior research fellow at the Oxford Institute for Energy Studies in Britain, any forced sale of assets would deprive utilities of a stable source of income and leave them open to the cyclical price troughs of the energy market. "The steady, regulated return from a [distribution] network is a useful stabilizer to the roller-coaster returns from the unregulated wholesale energy supply business," he says.

At the same time, utilities are facing stiff environmental rules that could be a major strain on their finances. The European Union is demanding that one-fifth of power generation come from renewable energy sources, such as solar and wind, by 2020. To meet the ambitious targets, Europe's big energy companies have unveiled multibillion-dollar initiatives to reduce carbon emissions and switch to new sources.

Ironically, the mass rush to green technologies is prompting record demand—and lifting prices—for components such as wind turbines and solar panels. Yet with little choice in the matter, companies are forced to plow ahead, even at the expense of their financial performance.