A Green Merger

Why the impending merger of two Canadian energy giants should give environmentalists hope.

News out of the energy sector in the last few days that should give lift to all of us with an interest in seeing a transition to a more environmentally sustainable energy system: TransAlta, one of the country’s largest independent power producers (and one of those most reliant on coal-based generation) is bidding to take over Canadian Hydro Developers (TSX: KHD), one of the country’s largest developers of wind and hydro electricity projects.

At one level, the story is a basic one: TransAlta is looking to diversify its generation base – away from coal and into renewables – as part of a corporate diversification strategy, and KHD presents a very attractive target for doing so. The story is made more compelling by the fact that the two parties – after attempts by TransAlta to initiate a “friendly” takeover – are now in a “hostile” takeover situation. Left at this level, the scenario is one that is seen every day in the business sections of our national newspapers: two companies locked in an important struggle for their future.

Digging a bit further down, though, reveals that two interesting new drivers in corporate decision-making are at work here. Those drivers have a larger significance, and may prove critical in shaping our energy sector in years ahead in ways that should give environmentalists comfort.

The first of those is the role of public subsidies for renewable electricity. Recent policy initiatives across the country, including most notably Ontario’s Green Energy Act, have created a regime of production subsidies for renewable energy in all its forms. In Ontario, the feed-in-tariffs established as part of the new legislation will pay electricity generators very attractive prices.

These incentives, and others like them, materially affect the basic economics of renewable electricity, and substantially increase the value of generating assets that are in a position to deliver such kilowatts per hour into the grid. Add to that the fact that the Green Energy Act sets no upper limit on the amount of electricity the province can buy at those costs, and that other parts of the Act serve to guarantee Ontario access to renewable generators: it’s clear that companies that are well positioned to deliver renewable electricity into the Ontario grid make very attractive targets for any investor. It should come as no great surprise, then, that KHD has a particularly strong presence in Ontario, highlighted by the new wind farm it has recently built on Wolfe Island, off Kingston. Any renewable energy company based in Ontario, in fact, should anticipate the kind of interest that KHD is currently receiving – wanted or not.

The second important driver is the pricing of emissions. Wednesday's Globe and Mail piece by Shawn McCarthy hints at this dynamic: “[TransAlta] could use new projects planned by Canadian Hydro – as well as those TransAlta is currently developing – to offset emissions from its coal- and natural-gas-fired plants in order to meet federal climate change regulations that are expected to be announced later this year. However, until the federal government unveils its regulatory framework for the power sector, the value of the credits generated by renewable power sources remains uncertain.”

In other words, the anticipation of a coming federal carbon “cap,” and the scarcity and cost that will create, are now thought to be sufficiently certain to provide an economic and financial argument for corporate leaders to actively develop and acquire low-carbon energy assets.

That is a huge step. Based on my experience in these matters, it is probably the first deal of this size and kind in Canada that has used future carbon pricing as a motivating factor. We really have reached the point at which corporate Canada believes that this is no longer an “if” decision, but a “when” decision, as has been hinted at for so long.

Moreover, if one of the sticking points in the hostile takeover is the valuation that each party would give to KHD, one cannot help but wonder – especially given what McCarthy is hinting at above – how much future forecasts of carbon pricing play in that dispute. TransAlta is moving ahead of any regulatory clarity, probably on the logic that without that clarity and specificity it can claim a lower “value” for the KHD low-carbon assets. KHD’s strategy, obviously, would be the opposite: to see how much the firming up of the regulatory structure actually increases the value of those assets.

In a sense, then, whether or not this takeover takes place is secondary to the important milestone it represents in corporate development in Canada. Put simply, policy instruments that are designed to promote low-carbon energy development are now having an impact on investment, capital allocation, and corporate development decisions. That is reason enough to celebrate.