SSE (>> Scottish and Southern Energy) aims to turn up the heat on top-ranked British Gas with a merger of its UK power and gas retail operations with those of npower, owned by Germany's Innogy (>> Innogy SE).
The deal will bolster second-ranked SSE, creating a supply group with 11 billion pounds in combined sales that could kick off a consolidation in the British energy market where established firms are battling smaller, nimble rivals.
The roughly 11.5 million customer accounts of the new firm would move SSE closer to Centrica's (>> Centrica) British Gas, which has more than 14 million.
The company, in which SSE would have a stake of about two thirds, and British Gas would together control more than 50 percent of the market, but Innogy Chief Executive Peter Terium said he was confident British regulators would approve the deal.
"When we look at the competitive landscape and the uncertain political environment for energy retailers in Great Britain, it is clear that npower would be better placed to offer value to our customers and our shareholders as part of a new company," Terium said.
The deal, which needs support from SSE shareholders and Innogy's supervisory board, would cut the number of big energy retailers in Britain to five from six. Closing is expected in late 2018 or early 2019.
By merging their retail units, Innogy and SSE form a group with pro-forma sales of 10.9 billion pounds and operating profit of 123 million pounds in 2017. It is expected to become a small or midcap stock once listed on the London Stock Exchange.
Innogy and SSE are advised by Goldman Sachs and Credit Suisse, respectively, Terium said.
Smaller rivals, often able to offer cheaper deals due to lower overheads, now control around 20 percent of Britain's market up from less than 1 percent a decade ago. Analysts expect further consolidation in future.
Rival E.ON (>> E.ON), one of Britain's big six power suppliers, on Wednesday said it had lost 200,000 customers in Britain so far this year.
Overall, there are around 60 energy suppliers operating in Britain at the moment.
"Given the interference in the market with the price cap, and pressure on margins, the natural reaction is for companies is to try to gain scale," said Peter Atherton, an associate at consultancy Cornwall Insight.
Britain's Competition and Markets Authority (CMA), which will need to approve the merger, said it was aware of the deal but would not comment when asked if it would give its approval.
Analysts expressed concerns about potential problems combining Innogy's and SSE's IT platforms, which according to Bernstein run on two different systems.
"While SSE and Innogy can sever a toxic limb through the transaction, 100 percent of RetailCo's earnings will be exposed to UK political risks and competitive risks," Deepa Venkateswaran, senior analyst at Bernstein, said.
SSE will hold 65.6 percent of the new entity, which will not include its business retail and Ireland operations. Innogy will hold the rest. It will receive a 60 million pounds break fee if SSE fails to get approval for the move by July 31, 2018.
"This process is likely to take some time and in the interim we remain absolutely focused on the critical job of delivering for customers," said Alistair Phillips-Davies, Chief Executive of SSE.
(Editing by Maria Sheahan and Edmund Blair)
By Christoph Steitz and Susanna Twidale