Resilience Amidst Transformation: The Evolving Landscape of Gas Local Distribution Companies

Resilience Amidst Transformation: The Evolving Landscape of Gas Local Distribution Companies - A North American Perspective

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In the ever-evolving landscape of natural gas distribution, Local Distribution Companies (LDCs), owners, and potential investors like private equity firms, find themselves at a critical juncture. Despite a rich history and a decade-long 6% Compound Annual Growth Rate (CAGR) in the US gas market[1], LDCs now face unprecedented challenges that demand strategic foresight, innovation, and in some cases, a willingness to consider M&A alternatives.

The utilities LDC M&A market has recently witnessed increased activity, driven by larger integrated utilities seeking capital infusion for expansion into renewables, T&D buildout to support electrification, and other infrastructure-intensive strategic priorities. Today, many of gas & electric companies are exploring divestiture opportunities across their gas distribution portfolios. There has been a notable uptick in LDC sales already, with nearly a dozen high-profile transactions closing in the last three years, and more pending announcement:

Whether you are a prospective buyer or seller, as you navigate the landscape of LDC M&A certain considerations are paramount. These considerations include conventional priorities like greenfield growth opportunities and policy head- or tailwinds, however they may also include less conventional elements, like the scale of an LDC’s pipeline replacement portfolio. This article is tailored for those at the helm, offering insights into the current situation, energy transition impacts, buyer perspectives, and actionable strategies.

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Buyer Beware: New, Old Challenges to the LDC Industry

While the gas LDC industry has had a long legacy of driving economic development in the communities they serve, along with strong financial performance – there are some significant headwinds the industry is facing today.

1. Pro-Electrification Policies: Increasing political pressure for states to enact policies favoring electrification over other energy alternatives. This is creating a challenging environment for gas-oriented businesses and presents a future risk of stranded assets.
2. Aging Infrastructure: Over 70% of LDC pipelines in the U.S. have surpassed their useful life already or will surpass it in the next decade[3][AB3]?. Ensuring the safety, reliability, and regulatory compliance of gas distribution networks will require significant attention and investment in the coming years.
3. Stringent Safety Rules: Recent incidents have led to the introduction of more stringent safety rules and guidelines, adding complexity and costs to daily operations.

1. Mounting Pressure on Customer Bill Affordability: The relentless growth of utility Capital Expenditure (CapEx) poses a threat to customer bill affordability. Utility CAPEX growth is 2x – 3x greater than broader GDP growth, yet consumption patterns are flat-to-declining. This trend has resulted in intense regulatory pressure to manage spend.
2. Consumer Incentives Promoting Conversion from Gas: The historic Inflation Reduction Act incentives could reduce the average price of electrifying a home by 79%, further accelerating energy transition, to the detriment of gas LDCs.

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LDC Buyer Perspectives: So what is the value for future buyers?

1. Infrastructure Funds vs. Private Equity: As private equity emerges with substantial dry powder, a 'musical chairs' scenario over the next two decades could drive substantial value creation.

2. Driving O&M reduction:? Leveraging modern technology platforms coupled with rapidly emerging technologies like GenAI is key to balancing cost objectives and operational imperatives.

• Administrative Efficiency: Recognize that inherited processes, systems, and infrastructure may be administratively burdensome. Leverage digital technology to streamline operations and enhance overall efficiency – particularly in SG&A overhead costs.
• Scalability: Assess opportunities where consolidation of LDCs can drive further synergies that may have been unreachable for stand-alone LDCs.
• Strategic Collaboration: Explore collaborations and partnerships (including non-traditional partners) to unlock hidden value, ensuring a seamless transition into the evolving energy landscape.

3. Opportunity for the next horizon of capital investment: LDCs that can successfully orchestrate “one foot in today, one foot in tomorrow” as it relates to a balanced decarbonization pathway will have line of sight to a long runway of capital investment growth.

• Opportunities in Gas Alternative Fuels: LDCs have opportunities to develop and operate infrastructure that supports less carbon-intensive energy sources such as Renewable Natural Gas (RNG), Hydrogen (H2), and Carbon Dioxide pipelines which are strongly supported by policy tailwinds.
• Opportunities for Other Effective Uses of Natural Gas: LDCs can explore alternative infrastructure investments in areas like district heating systems (leveraging geothermal) and heavy transportation fueling that would be particularly impactful to commercial customers.
• Continued Investments to Drive Operational Excellence:? Investments that support safety, reliability, efficiency of current network (e.g., mitigate leaks / incidents), and community resiliency (mitigate impacts of severe events)

4. Back to the Future?? The role expanded services can play: Given their customer and community relationships, along with their legacy business capabilities, LDCs can also explore future sources of revenue that can drivers of future growth.

• Resiliency Services (CHP): Explore opportunities in Combined Heat and Power (CHP) as a resilience service, providing both energy efficiency and reliability to customers.
• Enhanced Energy Efficiency Services: Leverage expertise to offer enhanced energy efficiency services, meeting the demands of a market increasingly focused on sustainability.
• Operator of Private Third-Party Infrastructure:? As more private businesses and municipalities leverage federal funding opportunities to develop or enhance their own energy infrastructure, there is a growing opportunity for LDCs to leverage their existing expertise, technologies, and platforms to serve these opportunities.

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Finally – Navigating the Complex Regulatory Landscape

In an era of increasing regulation, understanding how to navigate regulatory landscapes to maximize rate case and policy outcomes is imperative for any prospective buyer.? Deals involving regulated utilities must be acceptable to some, or all, of a variety of federal and state regulatory bodies. The states generally look at the day-to-day issues, such as the impact on rates, safety, and reliability – along with a long view on the alignment with the strategic priorities of the state.

?1.???Understand the statutory authority of each state: Looking at the role of state regulators, 50 of the 53 non-federal jurisdictions that Regulatory Research Associates (RRA) follows have some type of review authority over proposed utility mergers. In Indiana and Florida, preapproval by state regulators is not required before a transaction can proceed. Approval by the Texas PUC is required before a transaction involving an electric utility can take place, but Railroad Commission of Texas approval is not required for a transaction involving a gas LDC.?

2.???Understand the nuances and the complexity of each jurisdiction: ?In many jurisdictions, the stance of the regulatory commission is influenced by the positioning of key stakeholders, including elected officials, advocacy groups, and businesses – particularly as they relate to competing strategic priorities.?

• Proactivity Pays Off: Proactively develop and manage regulatory relationships from the outset. This positions the acquiring entity favorably and fosters a collaborative environment with regulators.
• Understand the Distinctions—and Points of Intersection Between Legal, Regulatory, Social and Political Drivers: Regulatory relationships and outcomes are influenced by a broad range of regional drivers. Some of these drivers impact LDCs in a variety of ways that extend beyond their regulatory influence. Success requires a comprehensive strategy to address all relevant externalities, rather than focusing exclusively on regulatory outcomes.

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Conclusion: Paving the Way Forward

For current LDC owners and prospective private equity buyers, this period of change represents both challenge and opportunity. Strategic adaptation, innovation, and collaboration will define success in this transformative era. By embracing the potential presented by the energy transition and charting a course that aligns with evolving market dynamics, LDCs can not only navigate the challenges but also thrive in the face of change.

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Co-authored by Omar Ghalayini, Jim Mazurek, Chris Colli and Omar Saadeh.

Note: opinions are our own and not necessarily the views of our employer.

[1]S&P Global, North American power: Following a decade of steady increases, further CAPEX growth is expected in the medium term link

[2]S&P Global, Accenture Research and Analysis

[3] U.S. Department of Transportation, Pipeline and Hazardous Materials Safety Administration, Pipeline Replacement Updates

[4] S&P Global, Regulatory Research Associates State Regulatory Evaluations, March 2024; Map credit: Arleigh Andes