Nigel Blackaby, Associate Editor
A five-year plan might be thought of something of a throwback to the days of Communist Party rule in Russia. But it was just such a plan that was put in place to reform Russia’s electricity infrastructure and for which Russia’s President Putin signed a package of legislation on the electric power industry on 26 March 2003 just over five years ago. So now seems like a good time to assess the results of that plan and look at the current prospects for Russia’s power industry.
The reform project has been overseen and driven through by Anatoly Chubais, the CEO of the state-owned power utility United Energy System of Russia (RAO UES), whose missionary-like zeal to keep the project on the rails has seen him overcoming resistance in the country’s legislative assembly, the Duma, and conducting a global quest to sell the concept of investment in Russia’s power sector to international investors. Today, Russia’s electricity sector has a very different look to it, yet there remains much more to do if a truly liberalized market in power is to operate.
The 5+5 plan
The last five years has seen the implementation of a programme of changes that have been long in the making. In fact, RAO UES’s reform agenda was known as the 5+5 plan, referring to the plan’s five years of preparation and planned five years of implementation. The reform was seen as a much needed response to failed attempts to improve the country’s energy supply reliability and increase investment in the power system which, after the economic downturn of the 1990s, had more or less ground to a halt, in terms both of capacity development and technological progress.
The upturn in economic conditions in Russia meant that an underfunded and aging power infrastructure was going to hamper growth. Adequate electricity supplies would be needed to sustain growing industrial output and support the increasing lifestyle expectations of Russia’s population. Real GDP was on the rise but despite the healthier position of the treasury, Russian leaders well understood the need to draw in new investment into the power sector. To do so, it needed to create ownership and incentives, allowing for the private sector to invest in the competitive areas of the market, while directing investment from the state sector to monopolistic sectors.
Under the reform process, RAO UES’s total monopoly position was to de-constructed with the separation and sell-off of stakes in the 72 AO-Energos, vertically integrated subsidiaries with monopolies over regional generation and distribution. Through a process of consolidation, these entities were to be transformed into six wholesale generation companies (WGCs) and 14 territorial generation companies (TGCs). Functions that were regarded as natural monopolies such as transmission and interregional distribution, dispatching and market operation were to remain owned by RAO UES. Strategically important assets such as nuclear power generation, which accounts for 23.24 GW and hydropower assets (HydroOGK), with installed capacity of 23.31 GW, were to be retained as separate operating units and kept under government control.
Five years on, RAO UES can reasonably claim that the sector restructuring is largely complete. The WGC and TGC companies it planned to establish to replace the AO Energos are now in place. A Federal Grid Company (FGC), separate from the generators, now has responsibility for the transmission of electricity and an Independent System Operator has been established. A competitive market for wholesale power, which now accounts for around 20 per cent of generation, has been created.
The justification for reform in terms facilitating growth and investment in the sector has been supported by the market’s direction. Russia has seen electricity consumption steadily rise since 1999 and in 2008 it is expected to reach a historical high of 1074 TWh, rising to 1198 TWh by 2010 based on a forecast annual increase of five per cent.
For the time being, the electricity sector in Russia remains dominated by RAO UESR through its ownership of the transmission system, the central dispatch unit and the FGC as well as its shareholdings in the generating capacity in the country. The state, in turn, holds a 52.7 per cent stake in RAO UES. This domination, particularly in the area of power generation, is not expected to continue as the industry moves into the final stages of the reform programme.
A number of the stakes in the WGCs and TGCs have been purchased by foreign utilities with Finland’s Fortum leading the way among strategic investors when it purchased one third of the share capital of Lenenergo in July 2004. This was the largest utility in northwest Russia and is now part of the TGC-1 grouping. Fortum recently also bought a controlling stake in TGC-10, which operates in the Urals and western Siberia.
Italy’s Enel and German utility E.ON have both taken positions in Russian generating companies and have gone on record as saying they have further investment plans in the sector. CEZ, the Czech Republic utility has expressed an interest in cooperating in the reform process and is working alongside TGC-4 to build a new power generating units. In March this year, Essen-based RWE became the second Germany investor to stake a claim in Russia when it bought the majority holding in TGC-12, leaving RAO UESR with just 11.4 per cent.
French power group EDF has also joined the party by entering into a partnership with Russian bidder TransNeftServis-S to acquire OGC-1, one of RAO UESR’s most valuable assets, with six power plants across northwest Russia. Compatriot GDF has stated that it is interested in looking at a strategy investment in a Russian electricity company. An increasing number of shares in the WGCs and TGCs are now traded.
While foreign investors have been grabbing the headlines, a few Russian investors have been quietly building up their positions in the sector, most notably state-owned gas giant Gazprom, which has recently agreed to pool its power and coal assets with coal producer SUEK and form a company that will account for 15 per cent of Russia’s electricity market.
Gazprom alone now owns a 10.3 per cent stake in UES and a further 25 per cent of the Moscow generating company, Mosenergo. Gazprom chairman and recently elected Russian President Dmitry Medvedev, says that the new company with be good for the country and will be planning an IPO. Critics fear that the reform and break-up of one state-owned monopoly (RAO UES) may just pave the way for a new monopoly to step into the role.
Other Russia companies that have bought stakes in the wholesale and territorial companies include Norilsk Nickel, Mechtel and Integrated Energy Systems (IES), an investment vehicle for billionaire Viktor Vekselberg. IES has positions in TGC-5, TGC-6, TGC-7 and TGC-9 as well as a number of local heat and power utilities.
The flurry of shareholdings in WGCs and TGCs that have come to market has generated quite some interest in the sector and helped sustain high valuations although there is some sign that the M&A euphoria has passed. Russia’s Alpha Bank says that business fundamentals are once again the main criterion for investors’ decisions and they are not optimistic about these. They point to the need for increasing capital expenditure as the short supply of power equipment and EPC expertize is pushing up prices. It also says that the absence of a functioning capacity market adds risk to WGC investments, as large-scale commissioning of new plant in 2009-2011 will put pressure on electricity market prices.
While European utilities have been willing to diversify into Russia, there has been relatively little interest from across the Atlantic or from Middle Eastern of Asian investors. One reason for this is the current strength of so many other power markets where capital can be allocated without so much (perceived) risk. US developers have yet to fully reverse their policy of retrenchment and have plenty of investment opportunities closer to home. Equipment suppliers and EPC contractors are eying opportunities opening up in Russia but again, the global boom in power projects means that operating under foreign jurisdictions cannot always be justified.
Investing in infrastructure
Based on an annual demand growth forecast of five per cent, RAO UES announced a new five-year programme involving the construction of an additional 40.9 GW of generating capacity. It aims to to add up to 160 new power units with an aggregate capacity of nearly 30 GW by 2010. This new capacity will be supported by 70 000 km of additional power transmission lines.
Annual Capacity Commissioning Programme (MW)
Source: RAO UESR
The main problem facing the Russian power industry at the moment remains the need to attract more investment, both foreign and domestic, in order to finance its refurbishment and expansion programme. It has had some success, with direct private investment in the WGCs and TGCs amounting to 740 billion roubles ($31.5 billion) last year alone. The proceeds came from additional shareholdings in the generating companies and the sale of government (RAO UESR) stakes in these companies. This process is continuing into 2008 with several share sales having taken place or planned for this year.
Not over yet
RAO UES has said that the electricity restructuring process is scheduled to be completed on 1 July 2008, after which RAO UES will be reorganized and cease to exist as a legal entity. It remains to be seen exactly how this will manifest itself. The government will still have a significant number of minority stakes in electricity entities that will need to be managed plus its position in the central management of system operation, market operation, holding in 11 interregional distribution companies and power transmission.
Despite the liberalization programme, the Russian government either directly or indirectly owns around 70 per cent of the power generation market and this is regarded with suspicion by some potential investors. The ultimate goal of doing away with subsidies and matching prices to actual costs remains elusive. The exact role and status and position of market regulator has also yet to be fully developed.
There remain a number of uncertainties, not least of which will be the future role of the dynamic Anatoly Chubais, who is, in effect, overseeing the dismantling of his own power base. The RAO UES boss continues to press for an expansion of the unregulated power market, the removal of price caps as soon as possible and, in the future, revisiting the privatization of the transmission network. He does not sound like a man ready to just slink away to his Datcha and reflect on a good five years work.