Russian sanctions and the power sector

EU sanctions have been in place since March 2014

Credit: European Union

EU sanctions are affecting the development and modernization of power projects in Russia, but it is possible to mitigate their effects, writes Alexey Gorlatov

Alexey Gorlatov

Russia’s power industry was formed a long time ago, and it is obvious that many energy infrastructure facilities are obsolete and require modernization.

In this regard the crisis and sanctions are naturally impacting the market for power equipment supply. Foreign suppliers face reduced demand for their output and services from Russian power sector companies, because of, among other things, the substantial exchange rate drop and relative instability.

However, in this context the Russian state programme ‘Energy efficiency and development of the power industry’, which includes a sub-programme entitled ‘Development and modernization of the electric power sector’, offers a positive impression, as the federal budget allocations for this sub-programme exceed RUB14 billion ($217 million).

Restrictions resulting from, or in connection with, the sanctions also have an effect on supply activity. For one example, a public tender for a power plant project in southern Russia failed because “some of the potential bidders felt it might put them at risk of being caught up in the sanctions imposed on Russia over the annexation, which prohibit individuals or entities under EU jurisdiction from investing in infrastructure projects in Crimea in the transport, telecoms and energy sectors”. The bidders included the Russian subsidiaries of E.ON, Enel and Fortum.

Russia’s current excess of generated power (some market players estimate the capacity excess at 20 GW) has a negative effect on the sector’s development, and this slows, to some extent, the construction and startup of new facilities as well as modernization of existing equipment.

As a result, many customers have effectively taken a wait-and-see approach, demanding certain supply conditions and preferences, whereas suppliers are losing out due to the fall in demand and the impossibility of implementing projects on the same scale as before.

Exchange rate risks seem to be one of the problems. Although such risks affect both sides, they obviously concern Russian equipment buyers to a greater extent, as their budgets are based on ruble revenues, and unstable exchange rates undermine management’s confidence in budget compliance.

It is worth mentioning that standard bank hedging instruments are still available on the market, but their price has risen so much as to wipe out any interest in projects, depending on their duration. Given that many projects in this sphere are quite long-term ones, this may be somewhat unprofitable for the customer.

A somewhat radical solution to this problem would be full payment in advance of the project price at the time of contract execution, though this might not be completely to the customer’s benefit. The latter would then be financing a long-term project up front and, even with a security from the supplier, this would still mean diversion of substantial sums.

Even so, one possibility might be to divide up a project into sections or separate stages. This might also be a quite convenient method for mitigating the exchange risk: if the exchange rate changes dramatically and rapidly, the parties could complete the current part of the project and then negotiate its future, or could agree initially on what to do in such circumstances.

Such an option obviously depends on the scale of the project and the possibility of implementing it in separate stages, but does appear to offer an alternative to direct currency hedging.

For this purpose, the parties would have to prepare a quite detailed contractual basis for dividing up the project in this way. This could include one framework agreement for the entire project and separate ones for each supply, or an overall agreement with conditions regulating the individual parts of the supply. Such contractual structures would need to be worked out in detail to protect the interests of both parties.

In 2014, as we know, the European Union imposed sanctions on different sectors, including supplies of dual-use materials and technology. The list of these is quite extensive, but the supply restrictions do not affect all buyers, and – with some exceptions – equipment or services may be provided to many customers. Even so, if customers in Russia are affected by the EU restrictions – if they are on the sanctions list or, for instance, their ultimate beneficiary is a so-called ‘military user’ – supplies of dual-use technology and products to them are prohibited. The general rule is that, if goods and services come under the sanctions, the supplier may always apply to the relevant bodies in its own state for permission to supply them – if the conditions set in relevant regulatory acts are met.

Often, however, both suppliers and customers in Russia wonder what will happen if new sanctions are introduced during the term of a contract. There is no universal solution to this. First of all, we are talking about future sanctions, and their terms are not yet known. Second, there are exceptions: for instance, a supplier can go ahead with the supply if the contract was concluded before the restrictions were introduced, though permission would still be required. If new restrictions are imposed, the parties could revise the supply terms, the conditions for use of given materials or equipment, or other conditions affected in any way by the new restrictions.

Jean-Claude Juncker reiterates his commitment to upholding economic sanctions


In this case, the parties should, again, focus particularly on their contractual work, making sure that the contract provides for them to regulate their relations, should such circumstances arise.

It is important to note that we are not talking about bypassing sanctions – we are talking about solving legal problems. And in this case, again, the parties should pay special attention to contract work – the agreement must provide for the possibility for the parties to regulate their relations in the event of such circumstances, which at the same time must be respected, and to preserve the balance of interests of the parties (this is possible through the use of, for example, conditional obligations, conditions precedent – Articles 157 and 327.1 of the Civil Code of the Russian Federation).

Of course, nothing prevents private companies, or even the state, from investing in the development of new technologies and improving existing ones – two years ago the Ministry of Industry and Trade and Ministry of Energy considered that an effective mechanism for technological development of the chemical complex would be the localization of foreign enterprises and joint ventures with foreign companies for the purpose of technology transfer.

However, the Ministry of Industry spoke some time ago about ‘reverse engineering’ – the Ministry plans to establish a Reverse Engineering Centre under the heading of the Development of Industry Fund. It will be used for developing domestic analogues of imported equipment. The reverse engineering itself, and its industrial use, may cause a lot of legal disputes and problems, including for the end users of such equipment – for example, if the equipment created through reverse engineering would violate the rights and interests of the relevant technologies’ owners, the latter will be entitled to apply to court for protection of their rights, including demanding that use of the equipment stop.

In the cases of the creation of home-grown technology and the acquisition of technology, especially in view of the possible introduction of additional sanctions, special attention should be paid to contractual work, including technology rights and the possibility of their use and transfer.

Russian customers increasingly demand that Russian law be applied to the supply contracts they enter into. At the same time, Russian legislation, which has recently undergone major changes in relation to contractual relations, provides the parties to the agreement with a considerable number of opportunities that were either not available previously – which might have been used in other jurisdictions – or required the use of complex structures.

For example, the contract under Russian law may include a warranty which specifies that there must be no violations of the rights of third parties in the equipment. If such a warranty were incorrect, it would give the purchaser the right to seek damages.

Nevertheless, given all positive changes in the Russian civil law, the parties – and more foreign suppliers – should pay attention to the exact wording of certain provisions of an agreement. For example, a usual condition on the application for liquidated damages requires a detailed description of the contracts under Russian law in order to give the term a similar mechanic: such a term is not currently known to Russian law, but jurisprudence recognizes the possibility of its application under certain conditions.

EU sanctions explained

Since March 2014, the EU has progressively imposed restrictive measures in response to what it calls “the illegal annexation of Crimea and deliberate destabilization of Ukraine”.

Some 146 people and 37 entities are subject to an asset freeze and a travel ban over their responsibility for actions which the EU states “undermine or threaten the territorial integrity, sovereignty and independence of Ukraine”.

In March 2014, the European Council decided to freeze the assets of individuals identified as responsible for the misappropriation of Ukrainian state funds. These measures were last extended in March 2016.

In July and September 2014, the EU imposed economic sanctions targeting exchanges with Russia in specific economic sectors. These restrictive measures: limit access to EU primary and secondary capital markets for five major Russian majority state-owned financial institutions and their majority-owned subsidiaries established outside of the EU, as well as three major Russian energy firms and three defence companies; impose an export and import ban on trade in arms; establish an export ban for dual-use goods for military use or military end users in Russia; and curtail Russian access to certain sensitive technologies and services that can be used for oil production and exploration.

These economic sanctions are in place until 31 January, 2017.

Alexey Gorlatov is Head of Commercial Practice at Goltsblat BLP, the Russian arm of international law firm Berwin Leighton Paisner

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