In this article, Drs. Tim Oliver Brandi and Carsten Corino of Gleiss Lutz describe the privatisation of municipal utilities that is currently taking place in Germany following the energy law reform of 1998 and they examine the opportunities and pitfalls that face potential foreign investors in this area. Gleiss Lutz is the German law firm with whom Herbert Smith have a strategic alliance
I. Public utilities as most important local energy-providers in Germany
In Germany, energy supply on a local level takes place primarily through municipal public utilities ("Stadtwerke"). Altogether there are around 950 public utilities in Germany, of which some 350 are still managed as public law institutions and approx. 600 are already managed as private law companies (limited liability companies or stock corporations). To a large extent, these public utilities still have a de facto monopoly so far as providing energy for the local consumer is concerned. That includes private households as well as commercial buyers.
It is common that different divisions of local services for the public are bundled together by utilities and regional energy providers. These divisions often include, in addition to electricity and gas supply, long-distance heating and water supply, as well as the disposal of waste water and garbage. Alongwith this, public utilities frequently provide other services, such as local public transportation, telecommunication and the operation of municipal swimming pools, parking garages, etc. Normally, only the energy supply divisions within public utilities operated at a profit in the past, while especially the divisions concerned with local public transportation and the operation of municipal swimming pools mostly produced losses. Thus the municipalities often used the profits from energy supply for the cross-subsidisation of the losses in the other divisions. German public utilities taken together achieve sales of some DM72 billion and employ 130,000 workers.
Until a few years ago, the utility companies and the other regional energy supply concerns belonged exclusively to the cities or other municipal regional authorities whose area is supplied by these concerns. However, especially since the reform of energy law in Germany in 1998, many cities have begun to privatise their utilities in whole or in part by granting private investors interests in the public utilities. To an increasing extent, foreign energy providers are entering as investors.
This article sketches the most important features of the privatisation of public utilities from the view of a potential foreign investor. To this end, it will first describe the new general framework for energy law and antitrust law for the operations of the utilities (see II below). Then it will depict the reaction of the utility companies to the modified general framework, in particular the wave of privatisation triggered by the reforms (see III below). After this, the article will briefly describe the typical course of such a bidding process (see IV). In conclusion, for the sake of illustration, the article will address some typical legal issues that arise in connection with the privatisation of utilities (see V).
II. Reform of energy law in Germany
Before the reform of energy law, the goal of German energy law was to avoid competition. The local providers simultaneously operated the networks and delivered the electricity. Antitrust law protected this for instance in the relationship between the public utilities and the regional electricity providers that operate the transmission networks. Prices for customers were high.
On the basis of the 1996 EU-Directive on the internal electricity market, German energy law was fundamentally reformed in 1998. Lawmakers eradicated the exceptions to anti-trust law and granted everyone the right to build direct lines in public streets.
Most notably, however, lawmakers created a right on the part of providers of electricity to transmission over third-party networks for a fee. While all other member states of the EU turned to a state regulator for establishing fees and further conditions for transmission, the federal government of Germany left the specification of terms of third-party access to the energy providers and customers involved (negotiated third party access). The interested groups on the side of both the producers and the consumers reached an initial agreement that exhibited considerable deficiencies. Thereafter, however, a second association-agreement of December 1999 ("Verbändevereinbarung – VV II") and the increasingly competition-friendly interpretation of the law by the antitrust authorities and the courts generally made fair competition possible for electricity customers for the first time. Yet there still exist considerable differences in respect of network-use fees, which differences can only partially be attributed to structural differences in the areas being supplied. Consequently, the discussion is still continuing about the necessity for a detailed ordinance or a regulator for the use of the electricity network and both will probably be demanded by Brussels anyhow.
The national electricity providers and newly founded enterprises offered economical electricity nation-wide - even in the previously protected areas of the public utilities. Customers switched from utilities to their new competitors. As a result of this, the utilities also had to lower their prices. Prices for household customers decreased by up to 30% and for industrial customers by up to 50%. Because the electricity suppliers in the end lowered prices in largely parallel fashion, only some 4% of household customers and a good 10% of commercial customers switched their electricity supplier as a result. At a more or less constant level of electricity consumption, this price drop for electricity led to considerable declines in sales and profits.
The gas industry is lagging behind the electricity industry. In the first place, only now are German lawmakers transforming the guidelines for the domestic natural gas market into national law, i.e., into a special regime for third party access for gas. Secondly, the first association agreement on gas concluded by the interest groups involved does not do much to foster competition. Finally, certain structural differences exist between the gas industry and the electricity industry. Thus there is for example in the gas industry in Germany a heavy dependence on a few foreign gas producers and, in contrast to the electricity industry, no overcapacity. The federal government is calling for a similar expansion of competition for the gas industry to that of the electricity industry. With the implementation of the natural gas guidelines and an improved association agreement, we should expect a development of competition and decrease in prices fundamentally similar to, though not as intense as, those of the electricity industry; if this does not happen, the federal government has announced that it will undertake sweeping measures, including the establishment of a regulatory authority. This competition will lead to further strain on utility companies.
Finally, the recent Commission proposal for a full legal unbundling of integrated energy companies with more than 100,000 customers will require reactions of the utilities.
III. Reaction of the public utilities: privatisation
The altered general framework has led – in addition to greater customer orientation – to a variety of reactions by the public utilities. Utilities are co-operating with one another in order to achieve more economical purchase prices for electricity and eliminate costs by combining their powers. An example here is the nationwide Energy Network Kommunal (enetko). Some utility companies are looking for a close business co-operation with a national energy provider. Thus, for example, the largest German energy provider, Rheinisch Westfälische Elektrizitätswerke (RWE), offers sales-partnerships through which the municipal services sell electricity from RWE in their own name to longstanding customers; the sale takes place, however,for the account of RWE, and the utilities receive only a fixed commission. Occasionally, there are also mergers of utilities.
The most important reaction of the municipalities consists, however, in the privatisation of their public utilities, i.e., the partial or complete sale of the enterprise to private investors. Most of the private investors are large, private energy supply concerns who desire by this means to gain better access to the local, final supply stage. Cities and municipalities expect that through the inclusion of private investors the financial position of utilities will be strengthened by private know how and capital, as well as through the realisation of synergies.
In order to become privatised, public utilities organised as a public institution must first carry out a transformation into a private legal entity. Privatisations of utilities into private legal entities take place, probably without exception, by means of share deals. Sometimes the inclusion of the private investor takes place through a capital increase. More commonly, however, it happens through the municipality’s selling a minority - or even majority - shareholding in the municipal services provider to the private investor. The proceeds gained thereby are often used to pay off the debts of the municipality, or for specific investment plans.
Some 250 of the 600 utilities which have already been reorganised as a private legal entity have a private third party as shareowner. As a rule, though, the shareholding of the private investor still consists in a mere minority shareholding. Examples of recent privatisations are the partial or complete sale of Stadtwerke Kiel to TXU, of the large Hamburgische Elektrizitätswerke to Vattenfall, of Elektrizitätswerk Wesertal to the Finnish electricity concern Fortum and of Stadtwerke Düsseldorf to Energie Baden Württemberg, which is affiliated with Electricité de France. A strategic partner is currently being sought by, for instance, the utilities in Hanau, Braunschweig, Lübeck and Frankfurt on Oder.
If a foreign energy provider wants to get a foot in Germany, the acquisition of a municipal services provider represents in principle a suitable stepping stone. But if the acquisition of a municipal services provider is not to become a stumbling block in the move into the large German energy market, various legal guidelines must be heeded.
IV. General framework and bidding process
Should a municipality wish to privatise its public utility, various legal requirements force the municipality to choose the private investor by means of a structured bidding process. It is not legally permissible for the private investor and the municipality to enter into negotiations without having first carried out such a bidding process for the choice of the investor.
The requirement for carrying out a bidding process is laid down primarily by municipal budgetary law and EU law on state aids. Under these requirements, municipalities are obliged to sell their shares in utilities at "full value", i.e., at the price obtainable on the market. Such a price can be determined only by giving different bidders equal opportunity in a transparent procedure to make an offer for the acquisition of shares in the public utilities to be privatised.
Even more far reaching requirements for the bidding process could result from German and European law on the award of contracts. If a municipality, for example, awards to the utility an extensive commission for supplying water or disposing of waste, and does so shortly after the inclusion of the investor as a new shareholder in the utility company, then the same legal requirements apply as for a public award of a commission to a private company as such. In this case, the strict procedural rules of EU law for the award of public contracts, and the corresponding rules which have been implemented into German national law, must be heeded.
In order to comply with these legal requirements, a largely unified practice for the bidding process for the privatisation of public utilities has developed in the last few years. This practice corresponds to the customary procedure of a structured bidding process for the sale of enterprises in the commercial economic sector: as a rule, the planned inclusion of the private investor is first publicly announced across Europe, in order to invite potential bidders to express interest. In the course of the subsequent privatisation procedure, the bidders first make a non-binding offer on the basis of an information memorandum in which the enterprise to be privatised is presented to the bidders. Afterwards, selected bidders are granted access to further internal information, disclosed in data rooms, about the enterprise. On the basis of the knowledge thereby gained, the bidders can thereupon make a binding offer.The victorious investor is then determined through largely parallel contract negotiations with the remaining bidders.
V. Typical legal issues surrounding the privatisation of public utilities
In connection with the privatisation of utilities, similar questions occur regularly that have to be settled in the privatisation contracts between the private investor and the municipality.
Firstly, the relationship between the private investor and the city, as future joint shareholders, have to be legally established. Here we find most prominently agreements regarding the filling of executive posts of the municipal services provider. Furthermore, arrangements are often made regarding financial contributions by the city and the investor for future investments within the municipal services provider. In addition, mechanisms should be agreed upon for resolving conflicts between shareholders. This can also involve their granting each other put or call options for the sale or acquisition of further shares of the municipal services provider.
Secondly, privatisation contracts usually contain provisions regarding the financial health and future development of the privatised enterprise. Of particular relevance here, from the perspective of the investor, is that the city assures, in the form of guarantees, the existence of essential financial foundations for the investor’s investment decision. Furthermore, it will be important to him to settle on provisions for securing future sales and his entrepreneurial returns. Conversely, the city often endeavours, in the interests of its residents, to contractually set fees that are as stable as possible or even decreasing. In addition, the city will often be tempted to contractually oblige the investor to make additional investments at the business site of the municipal services provider, and to protect the continuing existence of the current plant and employment relationships of the municipal services provider. In light of these conflicting positions, it must be an aim of the contract negotiations between investor and city to find an adequate reconciliation of interests.
Thirdly and finally, the question often arises of how, even after privatisation, the returns of the profitable divisions of the municipal services provider can be used for the cross subsidisation of the divisions running deficits. In the main, the private investor wants a shareholding exclusively in the profitable divisions. The municipality, by contrast, would like as a rule to maintain the cross-subsidisation to the largest extent possible. Here the concern of the municipality is often that it be possible to set off losses from the deficit-running divisions against surpluses of the profitable divisions for tax purposes. Different models are available for resolving this conflict of interest between private investor and municipality. According to one model, the deficit running divisions remain within the municipal services provider, while the private investor has a participating interest in the results of the profitable divisions alone, in the form of a so called "tracking stock". As an alternative to this, it is conceivable that the municipal services provider spins off its deficit running divisions into a new affiliated company. By means of the transformation of the enterprise into a partnership, or through the use of profit transfer agreements, the profits and losses of the two companies can then be set off against each other at the level of the city or an intermediary holding company.
As a result, the questions that have to be settled in the privatisation contracts always depend, however, on the particularities of the operational and legal structure of the municipal services provider in question, as well as on its financial health.
"© Herbert Smith 2002
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