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M&A deals in a market in turmoil


Published: 04 Aug 2022

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The UK’s energy security is in a state of flux. Rising inflation, interest rates and fuel prices, windfall taxes, and fuel embargoes are shaking things up, but what does it mean for M&A? Katherine Steiner-Dicks reports

No one ever thought the transition to net zero was going to be easy. But neither was anyone really prepared for Russia’s brutal renewed invasion of Ukraine and the impact it’s had on energy supply, particularly in Europe, in the immediate term. The cost-of-living crisis, in part as a result of the invasion, is certainly focusing minds. 

In extraordinary times like these, when energy supplies become weaponised or sparse through acts of war, climate change or supply chain weaknesses, the UK as an island nation must act more swiftly than most. Separated not only by water, but by political will from its neighbours in a post-Brexit world, the UK government must work doubly hard to ensure energy security.  

Arguably, the most sustainable way to do this is through unprecedented levels of investment in renewable energy and intermittent power technologies. Each of these attracts a different set of investors and risk-return expectations.  

European Commission President Ursula von der Leyen confirmed in May that more liquefied natural gas (LNG) is coming to Europe from the US and that imports from the Middle East and North Africa would also be stepped up, with new LNG terminals in Greece, Cyprus and Poland soon becoming operational. The related pipeline infrastructure will be the basis of future hydrogen corridors. She’s not the first and unlikely to be the last to say that hydrogen is the “new frontier of Europe’s energy network”. In the foreword to the British Energy Security Strategy, UK Prime Minister Boris Johnson speaks of “Britain’s inexhaustible resources of wind and – yes – sunshine” to get the nation through the energy crisis, and also refers to hydrogen: “We’re going to produce vastly more.” But dependence on oil and gas won’t disappear overnight. 

New era energy M&A 

What does all this market flux mean for deals? Gavin Quantock, KPMG’s head of energy M&A, says there’s an incredible amount of activity across all of the energy sector at present: “If you look at the market drivers – zero-carbon government initiatives, multinational renewable reinvestment targets and institutional demand for ESG-led deals – it’s clear to see why it’s never been busier in terms of deals coming to market and strong valuations.” 

Tim Short, a partner in 3i’s infrastructure team, agrees that record levels of investment gravitating to the energy sector is a trend that’s here to stay: “I don’t see Russian gas coming back into the energy mix any time soon. It’s going to take a lot of investment to replace that supply gap adequately, whether that’s over five or even 10 years.” 

Quantock believes there will be huge scope for “large volumes of investment, development, construction, company recycling in both the short and medium term” – a view expressed by Johnson in the British Energy Security Strategy. 

Storage and transfer infrastructure investment is an issue for offshore wind. “We could also see the capacity restriction removed for offshore wind,” adds Quantock. “The UK could aim to build out as much offshore wind as possible. That is, if it’s sensibly priced.” In June, UK Export Finance backed a £100m working capital loan to JDR Cables, which will enable the north-east-based company to build the state-of-the-art submarine cable facility it announced in September 2021. 

Nuclear option 

There’s also ambitious talk of new nuclear power plants in the UK. In May, the UK Nuclear Decommissioning Authority (NDA) and Cwmni Egino announced they’re working together on proposals for a new nuclear development at Trawsfynydd in Wales.  

The collaboration already has the agreement of the UK Department for Business, Energy and Industrial Strategy (BEIS) and is likely to be home to Rolls-Royce’s first small modular reactor (SMR). The first SMR is to be connected to the grid by 2029, with a chain of SMRs expected to follow as part of a larger project. 

The Rolls-Royce SMR project is reportedly “fully funded”. It has attracted finance from BNF Resources UK, Exelon Generation and the Rolls-Royce Group, as well as £210m from the UK government (following up to £56m over three years in 2017 to support research and development) and £85m from the Qatar Investment Authority. The pool of potential future investors has no doubt been reduced somewhat by the government’s National Security and Investment Act  – possibly for good reason in the current climate. 

Sourcing vital materials for nuclear power is crucial to bringing more SMRs online, and that could prove tricky. Uranium is not domestically sourced and historically has come through supplier-non-grata, Russia. In 2020, the biggest miners of uranium were Kazakhstan (41% of world supply), Australia (13%) and Canada (8%). 

Mining, a large part of the traditional energy sector, will also be part of the clean energy transition – lithium (batteries), silicon (for chips) and rare earth permanent magnets for wind turbines and electric vehicles. Access to these materials will increasingly present their own challenges. 

“The materials and commodity prices are going to challenge the downward cost trajectory of some of these asset classes,” warns Quantock. “While we have witnessed some fantastic reductions in costs, inflationary pressures and interest rate hikes could lead to an increase in prices.” 

Completion uncertainty

What’s been the impact of inflation and price volatility on deal processes? It’s made completion more difficult says Lee Downham, EY’s market segment leader for energy and resources, and is seriously testing economic models: “Inflation and market volatility are making deals harder to price, with increasing concerns coming from supply-chain disruptions. However, inflation is probably the biggest area of concern and focus right now. If you look at some of the most significant input costs related to the build-out phase of energy infrastructure, such as steel and labour, forming a view on how inflation will impact these costs is a real challenge.” 

It’s not a straightforward exercise working out build costs, let alone operating cost bases, he adds: “That makes valuations difficult and therefore raising finance harder. While some contracts will have protections linked to inflation measures and/or energy prices, it’s an unpredictable market and that introduces risk.” 

Despite the challenges, deal flow remains strong, he says, but not at the levels seen in 2021 when there was a big catch-up post-pandemic: “Deals appear to be taking longer to complete in the first half of this year, but if anything, longer term we expect to see deal flow accelerate to facilitate the energy transition more rapidly than previously was the case.”  

The Ukraine war might well strengthen Europe’s zero-carbon resolve. So far, UK deals completed in the sector have some catching up to do to match the count in 2021 of 102 – in the first five months of 2022, just 30 had been completed. Energy services companies remain the most popular M&A targets in the UK. In 2021, 40 service deals closed. So far for 2022, some 14 have been completed. Energy equipment deals are the next most popular segment. 

Further afield, we’re seeing clean energy consolidation plays happening among energy producers and supply-chain players. Notable deals include ENEOS Holdings’ acquisition of Japan Renewable Energy for $1.8bn and Aker BP’s $10bn acquisition of Lundin Energy. 

Despite institutional investors’ demand for increased levels of clean energy in their private equity and infrastructure portfolios, serious capital in the first half of 2022 has been gravitating towards traditional energy assets, such as oil exploration, LNG and mining – the latter of which will increasingly be targeted for the energy transition components and mass electrification.   

The UK oil and gas sector has notched up 15 deals in the first five months of 2022 valued at a combined $1.74bn. Deal flow in the European Union so far has seen 38 deals complete, valued at $11.77bn. But these figures are overshadowed by the US market, which had closed 89 deals in the first five months of 2022, valued at $23.93bn, reinforcing the theory that US demand for oil and gas could be harder to replace with renewable power. The previous year saw a whopping 323 oil and gas M&A deals worth some $77.7bn in the US. 

Green and brownfield renewable projects in the US and Europe have been attracting investment from the energy majors, private equity and infrastructure funds over the past decade, and will continue to do so, with offshore wind and solar taking the lion’s share of the capital. 

Immediate challenges 

“The reality is that governments don’t have the capital to fund the level of infrastructure required for mass-energy generation changes,” says EY’s Downham. “It’s going to take a lot of different forms of capital and finance to fund the transition, with different pools of capital attracted to the type of risk and return offered from the different type of assets – for example, nuclear, offshore wind or hydrogen, or investment into transmission, technology or other adjacent industries.” 

The risk-to-reward proposition will therefore be led by diverse sources of capital such as infrastructure funds, bonds, entrepreneurs and banks. Up until this year, there’s been a favourable phenomenon in the energy sector – the relatively low cost of capital – which has been in constant yield compression. That could all change. How windfall taxes in the UK and other jurisdictions affect investment programmes is another thing for the sector to think about. 

An increased number of power producers have announced financial commitments to renewable energy and energy transition investment – BP (£18bn), Shell (£25bn), Harbour Energy ($6bn) and Italy’s ENI (€2.5bn). There’s an argument that these commitments are a drop in the ocean compared with the majors’ traditional investments and targeted profits over the next decade.  

Renewable heavyweights SSE, ScottishPower, EDF Energy and RWE are taking the very likely scenario that the chancellor will greenlight a windfall tax on them better than expected. But any ‘levy’ on the electricity sector simply cannot impact renewable investment, for reasons of security of supply and the green transition. 

Until normality returns?

When is a windfall tax not a windfall tax? When it’s a “temporary, targeted, energy profits levy”. At the end of May, the UK’s Chancellor of the Exchequer, Rishi Sunak, unveiled just such a levy, with the aim of raising £5bn from oil and gas companies to help fund the £15bn package of support he simultaneously announced for households struggling with the cost-of-living crisis. He said the levy would be “phased out when oil and gas prices return to historically more normal levels”. Time will tell how long that is. 

This ‘economic update’ came just two months after the chancellor’s last mini-budget. Back then he warned that any windfall tax would discourage oil and gas companies from investing. The levy includes an investment allowance of 90% – a significant incentive to the oil and gas majors to reinvest profits – but will it bring investment forward in the short term? 

Deirdre Michie, chief executive of the North Sea trade body Offshore Energies UK, told the FT the new levy would “drive away investors and so reduce UK energy production” at a time when UK ministers want to bolster domestic supplies: “Right now, the key task is to prevent a flood of investment formerly earmarked for UK energy projects now being diverted to Norway, Saudi Arabia and Qatar.” 

There’s been no announcement of a windfall tax on electricity companies (at the time of writing). It’s estimated that could bring in up to £4bn. 

Infra allocations 

According to data from Infrastructure Investor, at the start of March 2022 funds in the infra market were targeting a cumulative total of around $200bn. Of those funds, 51% have a multi-regional remit. Europe is by far the favourite, accounting for 24% of fund targets, and Asia-Pacific 9%. Overall, around two thirds of those infra funds (by value) will target the energy and renewables sectors. 

Infrastructure assets under management (AUM) is expected to reach $1.87trn by 2026, according to Preqin estimates, making it the fastest-growing alternative asset class by fundraising and AUM. However, with more funds coming to the market this year, allocations to infrastructure will exceed current levels.  

Private equity firms that have made a name for themselves in the infrastructure space have already closed new funds this year: EQT’s $5.7bn active core infrastructure fund and Apollo’s $4bn Infrastructure Opportunity Funds III. 

Euro moves

At the end of May, EU leaders agreed further embargoes on Russian oil imports. It’s a moving feast. The ban covers all seaborne oil purchases – about two-thirds of Europe’s imports from Russia. Germany and Poland will also cut oil imports from the northern part of the Druzhba pipeline, the world’s longest pipeline that shifts black gold out of Russia. The ban is expected to cover 90% of Russian oil imports to the EU by the end of the year. 

Around 8% of the UK’s oil consumption is imported from Russia – it may be a low percentage, but it’s significant enough that it cannot be switched off instantly. It should accelerate the switch to homegrown offshore wind, and a revisit to North Sea oil and gas supplies.  

The UK and EU 27 are negotiating fuel contracts with a range of ‘reliable suppliers’ beyond Russia including the US, as well as Saudi Arabia. Only time will tell how oil and gas prices move as these measures take effect. 

Earlier in May, the European Commission published its RePowerEU plan, which aims to phase out Russian fossil fuels and fast-forward green transition. 

The plan is multi-pronged, including energy saving and diversification of supply initiatives, as well as increased investment in renewable energy sources. There will be an additional €210bn of investment to support the measures. The proposals don’t come without controversy – some €20bn of carbon trading allowances will be sold to help fund it. 

Roughly a quarter of Europe’s energy consumption comes from renewable sources now. The RePowerEU aims to increase that to 45% by 2030. European Commission President Ursula von der Leyen says cross-border cooperation must be stepped up to achieve this. 

Germany, which last year imported half its fuel from Russia, is looking at filling the gap with floating storage regasification units (FSRUs) for LNG. Installing FSRUs is quicker than building fixed terminals, but because of demand from governments across Europe, it’s not a cheap short-term solution. Germany has also recently announced a €220bn fund for hydrogen technology, EV charging networks and LNG infrastructure. 

As von der Leyen told the Davos 2022 conference in May: “The climate crisis cannot wait. But now the geopolitical reasons are evident, too. We have to diversify away from fossil fuels. We must accelerate our clean energy transition.” 

Keeping the lights on 

“Despite offshore wind projects being enormous by nature and capacity, there never seems to be enough capacity,” says Tim Short, a partner in 3i’s Infrastructure team, who says offshore wind in the UK will make up the bulk of infrastructure fund investment in the coming years.   

“By definition, they’re located offshore, which means they’re not near the core of demand,” he says. That, he believes, is why energy policymakers are not grasping the bigger picture and the role that flexible generation technologies and localised renewable grid connections must play to make such massive offshore wind projects viable.  

That’s not the only challenge that lies ahead. Short suggests the lack of government policies addressing industrial and consumer demand trends, such as the electrification of transport, could leave many of us in the dark due to renewable energy intermittency. “Big swings in renewable generation supply and demand on the system will be costly and passed down to consumers,” he says. “There’s an inevitable point where regulators across Europe will need to revisit the fundamental concept of market design and move towards capacity-based remuneration rather than what’s produced hourly, as it is now. 

“From an investor’s perspective, this type of uncertainty is not useful. It is, however, aligned with the principle that if you’re going to build a power station that has value and is essential to the grid’s function, you’ll be remunerated one way or the other.”