RWE (>> RWE AG) and Engie (>> Engie S.A.) are studying a possible share swap that could create a Franco-German giant in power grids, renewables and energy services with a market value of about 50 billion euros (£43 billion).
An Engie-RWE alliance would represent a breakthrough as the first truly cross-border utility in Europe since the EU began pushing for a single energy market decades ago.
Options being looked at could involve RWE swapping part or all of its majority stake in renewables and grids firm Innogy (>> Innogy SE) in exchange for a minority stake in Engie, four investment banking sources told Reuters.
No active talks between the top executives of the firms are under way, but the two utilities are discussing options and scenarios with advisers and bankers, the sources told Reuters. At this stage, no banks have been given a formal mandate.
"There are indeed talks ongoing, but that does not mean they will succeed," a French government source said.
An RWE-Engie deal could form the basis of a Franco-German "Airbus of energy" industrial alliance which was proposed by former French President Francois Hollande.
As long ago as February 2014, a joint French-German cabinet meeting in Paris discussed ways in which the two nations could cooperate in renewable energy and power grids, but overcapacity among European utilities dampened enthusiasm for mergers.
New French President Emmanuel Macron is keen to promote close ties with Germany and visited Berlin this week.
RWE shares traded 4.6 percent higher at 1435 GMT, while Innogy shares were up 3.8 percent after rising more than five percent. Engie shares initially rose 1.2 percent, then pared their gains to stand 0.6 percent higher.
French EDF has a large presence in Italy, while units of RWE, fellow German utility EON (>> E.ON SE) and Spain's Iberdrola (>> Iberdrola SA) are among the UK's "Big Six" utilities. However, these firms are all still mainly national players who have secondary interests in other countries.
An Innogy deal would make Engie a big player in Germany and Britain, where it has only a small presence, and strengthen CEO Isabelle Kocher's focus on grids and renewables.
Investors are warming to German utilities after a deal was struck with the government over storage liabilities as Germany ditches nuclear power.
Germans might be less enthusiastic about throwing in their lot with Engie. About 23 percent of RWE is held by municipal shareholders, who might fear that RWE would make ill-fated foreign investments, like E.ON did, and lose more influence through dilution.
"We struggle to see how swapping a majority stake in a stable, largely regulated German company which is well understood by the current management, for a minority stake in a part-state owned French utility, would enhance the stability and visibility of the dividend payment," Jefferies said in a note.
Brokerage Bryan Garnier said that while at first sight Innogy could fit perfectly with Engie's businesses, Engie's M&A track record is unimpressive as it has reported more than 10 billion euros goodwill impairments since 2008.
"In all and in the absence of further details, we believe that such a tie-up would be negative for Engie," it said.
Bankers said that any combination would have to wait for German elections in September, although one added that since the deal would not involve any plant closures and enhance French-German industrial cooperation, things could move very quickly.
A spokeswoman for Engie declined to comment but reiterated that CEO Kocher - following a Bloomberg report in March about Engie weighing a bid for Innogy - had said that Engie had no plans for a transformative deal.
Innogy, RWE and Germany's economy ministry declined comment.
One scenario that has emerged would see RWE swap part or all of its 76.79 stake in its listed unit Innogy for a direct minority stake in Engie. RWE spun off Innogy last October.
Bankers said that because of the strong undervaluation of RWE shares, a transaction could only take the form of an asset swap, not a cash deal. A certain cash component could be an option to adjust for differences in valuation.
RWE's stake in Innogy - whose market cap was 18.6 billion euros at the Thursday close - is worth about 14.3 billion, but RWE's own market capitalisation is just 9.6 billion, which means that all its other coal, nuclear and other energy assets are effectively assigned a negative value by the market.
Engie's market value was 32.8 billion euros at the same point.
One banker said that swapping its Innogy stake into that unit could give RWE a stake of up to one third in the new group.
Bankers say that any transaction would have to ensure a balance of power between RWE and the French state.
With the value of the French state's 28.65 percent stake in Engie at just under 10 billion euros, an asset swap involving all of Innogy could dilute French state holding company APE's Engie stake to about 20 percent in Engie-Innogy.
One banker said that RWE could contribute less than its entire stake in Innogy in a deal that would give RWE and the French state equal stakes.
This would require a law change in France, as the government is legally required to hold a one third stake in Engie. Bankers said this is unlikely to be a problem for the new Macron government.
(Additional reporting by Tom Kaeckenhoff, Christoph Steitz and Markus Wacket in Frankfurt and Emmanuel Jarry in Paris; Writing by Geert De Clercq; Editing by Jason Neely and Keith Weir)
By Arno Schuetze, Geert De Clercq and Julien Ponthus