AES, Enel, Europe

Russian Power: Buying the rumour and selling the fact

Issue 4 and Volume 15.

RAO UES’ pride may encounter prejudice from investors when the latter focuses beyond the presently tight power balances. Uncertainty continues to plague the power sector reform, for instance the incompatible cross-subsidised heat and power market or future power trading risks. Consequently, the lack of transparency will drive a new generation of independent investment projects, circumventing much of the concern originating from Russia’s transitional market.

Christopher de Vere Walker, DVW Group, UK

It is a truism, universally acknowledged, that a prerequisite for stable economies is a sound electricity sector. Therefore, governments worldwide reform electricity sectors to achieve one crucial aim, and that is to halt the decline by handing over investment responsibility to the private sector. After all, unlike governments, the private sector is no stranger to maximizing efficiency by investment and cost cutting throughout the value chain.

Russia is an important case in point, with a desire for investment that is greater and more time critical than most other developed countries have experienced. Since 2001, Russian deregulation and liberalization has meandered towards its final stages where investors are now speculating more actively on the attractiveness of the new market.

By global standards, Russia’s mammoth electricity reform is impressive, and naturally, those close to the top of Unified Energy Systems (RAO UES), Russia’s electricity monopoly, are passionate about the process. It is an impressive reform, not because it is transparent and seamless, but rather that it is largely achieving what it set out to do in a complicated climate skewed by political will and industrial lobbying.

Now in the final phase of reorganization, a combination of the familiar electricity market models borrowed predominately from America’s PJM, Scandinavian and other European electricity markets, are now more or less in place. Currently the market remains incomplete, since it lacks some of the segments characteristic of a fully formed electric power market. For instance, yet to evolve are: a system services market; a transmission rights market; a financial derivatives market; and a capacity trading market. Nevertheless, the fundamental mechanisms of Free Bilateral Agreements (FBA), Day Ahead Market (DAM) and the Balancing Market (BM) are there in name, despite the fact that the market participants have yet to experience the full force of their mercurial nature. Even so, the accrued cost of imbalances as of January 2006 already amounts to over 15 billion roubles ($577 million) and has shown no signs of abating.

In 2006, the electricity consumption in Russia was 984 billion kWh, which is close to Russia’s 1991 highest consumption level prior to the mid-1990s industrial decline. Last year’s reported increase of four to five per cent, reached the level of 156 GW of demand, while RAO UES predicts a further five per cent increase between now and 2010. Interestingly, Russia’s total available capacity is estimated at 220 GW. A cursory glance at the national supply and demand figures might lead one to suppose that Russia has ample reserves.

The reality, however, is very different because reserve capacity is not often advantageously positioned because of capacity constraints or a lack of grid connectivity. Subsequently, certain regions already experience shortage of supply; among them are Tumen, Sverdlovsk, Moscow and the Caucuses. The Russian’s adaptation of a nodal market, similar to that of America’s PJM version, is designed to signal where investment is needed within the grid, simply by being price sensitive. Undoubtedly, it is critical for the sake of the Russian economy to increase capacity strategically and sufficiently beyond that of the increasing demand. Therefore, one of the topics currently dominating the electricity market agenda is the programme of attracting investment into the sector.

The International Energy Agency states that Russia’s electricity sector needs a colossal $380 billion of investment between now and 2050. Anatoly Chubais, head of RAO UES, recognises that RAO UES needs to increase investment from $7 billion to $30 billion annually over the next several years. In January 2007, RAO UES announced a new investment programme. In accordance with the programme, $20 billion is to be invested into the electricity sector in 2007, three times more than in 2006. The overall volume of investment by 2010 is estimated to amount to $119 billion. The investment programme looks at both the financial parameters and the parameters of generation capacity to be put on line. The total volume of new capacity to be put on line in accordance with the programme is 40.9 GW, inclusive of 34.2 GW from RAO UES. RAO UES is anticipating to finance the programme by the means of: one, own funds (one-third of investment programme); two, 21 per cent by the means of additional issue of shares by existing companies and sale of non-core businesses; three, 7.2 per cent at the expense of the federal budget; four, 14.7 per cent by the means of attracting financing including bond issues. According to the company plans, more than ten new electricity companies are to borrow from 70 to 80 billion roubles ($2.5 to 3 billion), amounting to approximately 20 per cent of the volume of all corporate placements in 2006.

The investment interest in the Russian electricity sector became obvious at the end of 2006 when the reform moved into the stage of concrete decisions, steps and announcement of anticipated investment. The success of last year’s IPO by 1OGK-5 , where the company raised $459 million, reportedly four times over-subscribed, set the trend for the investment appetite. The recent bid for a 37.9 per cent stake of OGK-3 by Norilsk Nickel at $3.1 billion prompts market observers to question if these examples are reasonable market valuations given that there are still concerns over regulatory consistency and electricity price transparency.

Additionally, market players are living with the cross-subsidisation problems that exist within the heat and electricity sector. The heat market will remain regulated whereas the electricity market, over the coming four to five years, will gradually become 100 per cent liberalized (in 2006, 90 per cent of electricity was sold at regulated prices). The problem is that the two markets are currently integrated where pricing heat energy is done at the expense of electricity. On a global scale, decoupling the market of heat and electricity from combined heat and power (CHP) plants has never been completed satisfactorily and thus it remains a problem for Russian 2TETS.

In addition, the lowering of tariffs for residential customers at the expense of the industrial customers compounds this problem further. With the plan for tariff liberalization until 2011, market observers doubt that such tariffs will be liberalized at the same pace as the reform, so naturally the regulation of tariffs remains a key concern. In Russia, the average tariff increase in 2006 was 7.5 per cent against the average inflation of ten per cent. The tariff growth lagged far behind the growth of fossil fuels. These are issues of transparency that obscure the market’s attractiveness and they should eventually be resolved.

Risk appetite

In Russia, the demand for generating assets is largely fundamental since the overriding financial argument is based on supply and demand of electricity. This is, of course, an established trading principle for a normal commodity. Electricity, however, is not a normal commodity and those who treat it as one are liable to receive an electrifying shock.

Consumption is expected to increase a further 5 per cent between 2006 – 2010
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Western experiences demonstrated how investors could punish utilities, such as in the dramatic case of the Enron collapse, or the devaluation of TXU, Aquila, Duke, AES, and British Energy. Moody’s assessment during the past seven years, saw the average credit rating of the American energy companies decreased from A3 to BAA1. These are companies in significantly more developed markets, where transparency and regulatory risk are considerably more dependable than that of today’s Russian market.

Yet Western markets with similar market models to that of the Russian model have occasionally faced up to 1000 per cent volatility on the intraday market, requiring the adoption of a high level of risk appreciation and sophistication, which is an art usually practiced by the banks. Having experienced such volatility it is interesting to witness investors’ readiness to embrace the associated risks of buying into electricity assets, such as generation or sales companies in Russia, particularly in its embryonic period.

The investment enthusiasm in Russia’s electricity sector appears to know no bounds with further reports that Gazprom plans to take a controlling stake in OGK-2, OGK-6, 3TGK-1 , TGK-3 and TGK-7. This move may possibly call into question some investors’ confidence in the reputation of the reform, particularly in light of the recent oil and gas sagas. It is logical to ‘vertically integrate’ in the Russian electricity market as this has always been a Western strategy to protect the company in adverse market conditions, but it may not be the driver for Gazprom as it is the case for EvrazHolding, Mechel, Suek or potentially Norilsk.

Risk appreciation?

With electricity demand increasing in Russia at about three to five per cent per year, the likelihood of a narrowing of available reserve margin in some regions is dangerously apparent, so naturally the value of the assets are inflated. World valuation of the energy plants is based on the company’s installed capacity. The figure for the European countries is in the range of $1000-$2000 per kWh. In the emerging markets, it is approximately $800 per kWh (Brazil). The Russian energy companies are valued at $500-$550 per kWh and with some of them at the level of emerging markets.

Investment programme: $199 billion total until 2010
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Yet more concerning is that investors may not be factoring in future market risk, credit risk or regulatory risk quite as diligently as they should be due to the stage of the markets evolution, because of the current bias of supply versus demand. If this risk is not heeded then an interesting example to consider would be the UK, where in the market’s infancy, risk was often underestimated to the detriment of many of the original electricity players. At that time, the system allowed for generators to skew the electricity prices in their favour, which resulted in higher prices, followed by substantial investment into new generation assets, and subsequently a glut of electricity. When the market became more liberalized in 2001, the market was forced to absorb a 30 per cent excess of effective reserve and a painful price correction, so the plant efficiency was essential to avoid financial haemorrhaging or bankruptcy. Ultimately, the volatility and risk associated in the electricity prices fed through to the companies’ valuation.

While it is still unclear if the board of directors for RAO UES approves the plan of 100 per cent sale of the state’s share in six OGKs and 14 TGKs in order to attract investment, both Russian and foreign investors have demonstrated their interest in playing the Russian energy roulette. Gazprom, Surgutneftegas, KES, SUEK, Novatek, Norilsk Nickel, Enel, E.ON, Fortum and others are likely to participate in all IPOs of both OGKs and TGKs. In accordance with the plan, RAO UES is to hold 15 IPOs in 2007. The premium that the investors are prepared to pay for their shares would be the key driver behind their growth.

In order to secure their future position in the new companies, strategic investors are expected to invest into RAO UES shares in anticipation of swapping them for the shares of TGKs and OGKs. The acquisition of RAO UES shares today is likely to save almost 50 per cent on future investment into TGKs and OGKs. Other strategies include building a new generation of privately funded electricity plants of 50-100 MW designed to supply a specific industrial site. These ‘block stations’ shed much of the baggage associated with assets spun off from the reform, since deals can be struck bilaterally between the generator and the consumer. For much the same reason their attractiveness to foreign investors is significantly more straightforward. If they possess the right to sell excess electricity back into the grid then this will add further value for the investor. In some countries that right is difficult to obtain.

While OGK-3 and OGK-5 have reset the standards and raised the game, RAO UES may find itself nurturing a precarious asset bubble founded on hype and buzz. Valuating electricity assets is a complex business where the measuring stick needs to account for a multitude of different variables.

If we benchmark against other developing and developed markets, it serves to illustrate the uncertainties within the Russian market, much because of the glaring warning signs of the apparent lack of full market formation, or electricity companies creating front, middle and back offices to manage all the risk variables that may soon come to haunt them.

In conclusion, the rumour is that electricity-generating assets are investment buzzwords. The fact is electricity markets are the most precarious and temperamental in history. Well-seasoned investors are all too familiar with buying the rumour and selling the fact.

1 OGK – Wholesale generating company with assets placed sporadically throughout the Russian Federation and that is typically of strategic national importance (6 OGKs, plus Hydro OGK and Nuclear)

2 TETS – Russian CHP

3 TGK – Territorial generating company with assets clustered within a regions of the Russian Federation (14 TGKs in total)