INSIDE OUT: German utility E.ON is a really terrible company Powergen should be taking it over and pruning its overheads. Instead, E.ON is buying Powergen.

INSIDE OUT: German utility E.ON is a really terrible company Powergen should be taking it over and pruning its overheads. Instead, E.ON is buying Powergen. - At Quest, the online service for fund managers that I'm helping to develop, we run a simple quali

by ROBERT PESTON, editorial director, Quest,,e-mail
Last Updated: 31 Aug 2010

At Quest, the online service for fund managers that I'm helping to develop, we run a simple quality check on every European blue-chip company. We calculate the cash it has earned on the money invested over the previous 10 years. And we look at whether its capital base is growing or shrinking. This is the simplest and best way of determining whether it can be trusted to employ shareholders' money wisely.

A company that consistently earns positive cashflow returns in excess of the cost of financing the business is, by definition, a good company.

And if it does that at the same time as investing to grow, then it is a great company. Meanwhile, any company earning less than its cost of capital is rotten.

This is common sense. And if you are a follower of free-market fundamentalism, you would believe that all incremental capital would go to good companies and that the bad ones would be starved of investment funds.

Yet global capitalism does not work like that. Time and again, good money is thrown after bad. The airline industry, for example, is filled with mediocre companies that have never made a reasonable return, and yet investors continue to provide them with incremental financial resources to waste.

Now, an example of a really terrible company is E.ON, the German utility giant. Over the past 10 years it has never earned a return even close to its cost of capital (it would be more accurate to say this is true of Veba and Viag, which merged to form E.ON in 1999). In fact, during the past decade it has actually lost money in aggregate on a capital base that has grown by billions of euros - quite a feat.

By contrast, Powergen in the UK is a pretty good business. It has earned an 8% return over the past decade and beaten its cost-of-capital almost every year - all in the context of a tough regulatory climate.

In a rational world, therefore, Powergen would be taking over E.ON. The UK business' aggressive management should be going over to Germany, closing down its loss-makers and pruning its overheads. But the reverse is happening: E.ON is buying Powergen for EUR8.2 billion (pounds 5.2 billion).

How has this happened? The simple answer is that E.ON is an enormous company, with a market value of EUR56 billion and an estimated EUR50 billion of resources earmarked for acquisitions. Even after buying Powergen, it would have enough funds to buy the UK's biggest water business, United Utilities, its biggest gas company, Centrica, and its biggest electricity company, ScottishPower, and still have a few billion euros left in change.

Nor is the Powergen takeover an isolated example. Last year, RWE, the second-biggest German utility and an even worse-performing business than E.ON, bought Thames Water for EUR6.9 billion.

Perhaps none of this matters. Shareholders in Powergen and Thames Water are happy, because the German companies have given them a huge wodge of cash for their shares. Meanwhile, British consumers should not suffer significantly in theory, because Powergen and Thames remain subject to assiduous UK regulation by Ofgem and Ofwat.

But I feel uneasy. For one thing, it is rarely good for the prospects of employees or customers for a company to be under bad management. These deals are also a concern to other UK utilities. They fear RWE and E.ON will give unfair subsidies to their new British businesses, using their enormous balance sheets and apparent willingness to make losses.

So these deals raise substantial public policy issues, recognised by ministers, officials and regulators. They are uneasy about the takeovers and worry that there is not a single UK utility big enough to make substantial inroads into the German market. But they also say they are powerless to do anything about it.

Under EU law, the deals cannot be stopped. To attempt to do so would be deemed unfair discrimination against a member state.

One possible reform, hitherto favoured by Powergen, would be to change UK energy policy to allow far bigger mergers of UK utilities to create British national champions large enough to buy an RWE or E.ON. My view, however - which is shared by the government - is that this would be bad for domestic competition and therefore bad for consumers.

A more attractive approach would be to give national governments the ability to block a cross-border takeover on an assessment that the structure of the bidder's home market conferred some kind of unfair advantage. The UK government could try to insert such a clause into measures to liberalise European energy markets, which were delayed recently because of Franco-German opposition.

The problem is that, in the unlikely event that such a reform were ever agreed, it would not take effect for years. By the time Europe has a genuine single market in energy, it will probably be dominated by two lumbering Germans and a troika of behemoths from France and Spain. Any residual independent British businesses will be their snackfood.

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