Shares in SSE rose 3.28% to 1,419.50p on the news in afternoon trading.
The new business would merge SSE’s household energy supply and services business in the UK with Innogy’s British division, Npower.
SSE said discussions with Innogy are ongoing and are at a “well-advanced” stage but there is no guarantee that a merger deal will be agreed.
The combined business would be listed and SSE would demerge its shares to its shareholders.
A deal would be subject to regulatory and shareholder approval.
Merger may not get approval
"At first glance it’s hard to see how the regulator would let this one through," said Neil Wilson, senior market analyst at ETX Capital.
"Cutting the big six down to a big five would hardly help competition, which is exactly what the government wants. A merger would create the UK’s largest household energy supplier with a 24% market share, ahead of British Gas’s 22%."
The news follows reports on Monday that Innogy could sell Npower or combine it with a local rival as the business racks up losses and loses customers on the back of customer service troubles and higher costs.
"SSE probably thinks it can harness the customer base for a bargain price since Npower has been struggling for a while now. But the real question is whether regulators would let this one pass, and it’s hard to see it overcoming competition concerns," Wilson said.
A possible deal between SSE and Innogy comes as the so-called big six energy suppliers in the UK lose customers at a growing pace to smaller suppliers.
Smaller suppliers account for more than 8% of market share, compared to 1% three years ago, according to Ofgem data.
The big six are also facing an impact to profits from price caps proposed by the government.