By Siân Green
Russia’s power industry is embarking on a reform programme to attract much-needed investment to the sector. Capital is needed now to help avoid future power shortages, but is unlikely to start flowing until 2004.
Recent successful IPOs and Bond placements show that investor confidence in Russia is growing, says Sir Roderic Lyne, British Ambassador to the Russian Federation. “These are real votes of confidence in the rising economic stability of Russia.” However, says Lyne, the country still has a poor image in the boardrooms of the west, and “needs to close the credibility gap”.
Speaking at the Russian Economic Forum conference, held in London in April, Lyne noted that to ensure a strong economic future, Russia must establish a fair and free market and commit to reform. “Russia must press ahead with the restructuring and reform of its economy and integration with the global economy,” he said.
Russia is clearly committed to reform across many of its economic sectors, and top of its reform agenda is the power industry. As a central part of Russia’s future economic success and in desperate need of expansion and upgrade, the power sector needs to attract investment and it needs to do so fast.
Crying out for cash
Although the Russian power industry was historically well provided for during the communist era, little capital has been invested since the breakup of the Soviet Union. Although installed capacity stands at just over 200 000 MW – down from 213 000 MW in 1992 – only 170 000 is available. It is estimated that some 50 per cent of the sector’s fixed assets have passed their intended productive lifetime, and decommissioning of generation assets stands at five times greater than commissioning of new capacity. By 2010, up to 110 GW of generating capacity (including 10 GW of nuclear capacity) will have reached retirement age.
The supply balance in Russia is therefore becoming tighter as electricity demand increases. While electricity demand fell in the 1990s, demand increased in 2000 by 3.9 per cent to 817 000 GWh as the economy recovered from the 1998 financial crisis. Demand is expected to continue growing, reaching around 1000 GWh by 2005.
Investment in Russia’s power sector is therefore vital if power shortages are to be avoided in the future. Anatoly Chubais, CEO of Russia’s electric power holding company RAO UES, has stated that the Russian Power Sector will not satisfy demand in 2004-2005 if investments are not made.
However, artificially low power tariffs and non-payment of bills mean that the financial health of the country’s regional power companies, or energos, is not good. They cannot finance capital expenditures from their own cash flows. Annual investments in the sector stand at less than 20 per cent of the required amounts, according to Standard & Poor’s.
RAO UES has estimated that the overall investment requirements of the power sector are around $50 billion from 2001 to 2005, and will be even higher in subsequent years. More conservative estimates put the required investments at $20-35 billion over the next ten years.
Investment is required in the modernization, life extension and refurbishment of existing thermal and hydropower plants, in the construction of new generation facilities, as well as in the upgrade and development of transmission and distribution infrastructure in Russia.
Recognising the need for investment in the power sector, the Board of Directors of RAO UES developed a draft document of proposed reforms in 1999. At the end of 2000, this was submitted to the Russian Ministry of Economic Development for consideration. Intense debate followed, and in July 2001, the government approved a restructuring plan developed by the Ministry of Economic Development and based on RAO UES’ proposals.
The key principles of the reform plans are broadly in line with international trends of power deregulation. However, this will be the largest reform programme ever seen and will be a complex, challenging task.
As reform progresses, the sector will become virtually unrecognizable. Few companies will remain in their present form, and the sector will also function very differently, says Moscow-based broker Aton Capital. The reforms will see a massive programme of asset transfers and a restructuring of every company, and in the new market-driven sector, companies will fight to keep their costs low.
The restructuring will happen in three phases from 2002-2010. It will ultimately bring an end to the dominance of RAO UES, and create opportunities for investment in all sub-sectors, except, perhaps, the nuclear energy sub-sector.
The reform programme will involve the break-up of the industry’s vertically integrated structure. Generation and supply will become competitive markets, while transmission and distribution will be regulated monopoly activities. Key features include:
- Unbundling of the industry’s monopoly operations
- Creation of a national transmission company
- Creation of efficient portfolio generating companies
- Introduction of competition and transparent trading arrangements in generation and supply based on non-discriminatory third party access
- Price liberalization and tariff restructuring, and elimination of cross-subsidies
- Revision of regulatory bodies to reduce political intervention.
In the first stage of reform, from 2001 to 2004, the industry will be restructured in preparation for the introduction of competition, and the legal framework for the operation of the industry will be established. RAO UES’ transmission network will be spun off into a single Federal Grid Company and a transmission system operator will also be established.
The RAO UES-controlled power plants will be consolidated into ten generating companies, which, says UES, will have a competitive portfolio of assets, sound financial and operating performance with the ability to raise financing for large-scale new constructions. Each generating company will have a capacity of 8500-10 000 MW and will include some of the assets currently controlled by the energos.
The UES-controlled regional energos will be consolidated into 50-60 new RAO UES subsidiaries, and a single nuclear generating company will be set up to operate all ten nuclear plants. In addition, the main participants of the emerging wholesale market will establish a Trade System Administrator.
By 2004, it is envisaged that competition in the wholesale and retail market will be introduced, with up to 15 per cent of generated power sold on the wholesale market. Transmission and distribution tariffs will remain regulated.
In the second stage of reform (2004-2006), the operating rules of the competitive wholesale power market will be introduced along with full liberalization of the wholesale market. RAO UES will focus on its transmission and system operator roles, and the distribution assets of the regional energos will be spun off and transferred to a federal company.
Stakes in the new energos and generation subsidiaries could be sold at this stage. State tariff regulation will end, although the state will continue to regulate monopoly activities. Competition in retail will be introduced.
In the third stage (2006-2010), the focus will be on attracting investment to the market, including the large-scale sale of shares in generating companies and other commercial companies. The state will increase its stake in the Federal Grid Co and the system operator, and forward and futures market will be created for risk management.
In October 2001, UES signed a $90 million, 3.5-year syndicated loan with the European Bank for Reconstruction and Development (EBRD) to support restructuring and to repair transmission and distribution infrastructure. In addition, the UES Board of Directors has approved the transfer of $4.1 billion of the company’s assets to the Federal Grid Company, and the creation of the System Operator.
Speaking at the Russian Economic Forum, Aton Capital’s equity research director, Derek Weaving, said that he has been surprised by the rate of progress so far. However, Weaving noted the scale and complexity of the task ahead, and that a great deal more needs to be achieved beyond the structural element of the reforms.
A key part of the reforms – and potentially the most contentious part – is tariffs. It is clear that tariffs for end consumers must increase, and cross-subsidies be eliminated – in order for investment to flow. In spite of increases in electric power rates over the last two years, tariffs in Russia remain the lowest in the CIS region.
Share of main Russian power companies in generation
Tariffs in Russia are half those in Ukraine and Belarus, a third of those in Armenia and nearly four times lower than tariffs in Moldova. Tariffs need to be raised not only to make the market more efficient, but also to encourage energy efficiency among consumers. Cross subsidies protect residential consumers.
In January 2002, the government approved a plan to increase electricity prices by 20 per cent for the first half of the year. This was a smaller rise than predicted by analysts. Chubais has promised that tariffs will reach European levels within three years, but he is likely to meet political opposition along the way.
Another contentious issue is the valuation of assets when the industry is restructured. Speaking at the Russian Economic Forum, David Herne, portfolio manager of Brunswick Capital Management, pointed out that with so much of the industry in private hands, restructuring and asset transfer will be very complex.
Private shareholders were originally against industry restructuring, and through discussion with RAO UES and the government won concessions, including the proportional distribution of shares in future UES generating companies.
According to RAO UES, the reform process will open up the market for strategic investors to take up roles in upgrading and expanding existing generation facilities, initiate new greenfield projects, and eventually acquire controlling stakes in portfolio generation companies and regional energy supply companies. This in turn will improve reserve margins and security of supply.
However, real investment is only likely once the restructuring begins in earnest. People familiar with the market believe that it will be four to six years before investments start to flow. Yuri Udalstov, RAO UES’ head of corporate strategy, told PEi that investments will start in 2004-2005, and will come predominantly from international companies.
A number of international energy companies have recently expressed an interest in the Russian power market, while several international equipment manufacturers have been active there for some time.
In early 2001, Shell Gas and Power signed a memorandum of understanding with RAO UES to evaluate possible commercial power ventures.
German power giant E.ON has also made its first tentative step into the market. In March 2002 it signed a letter of intent with RAO UES to study the possibility of building up to 1000 MW of generating capacity. Both companies stated that in implementing this project, they wanted to demonstrate to foreign investors the real possibility and feasibility of building a power plant in Russia with international investment. Under the plans, two combined cycle gas turbine units will be built in two phases in the central or northwestern part of Russia.
Other international companies to have expressed an interest in Russia include AES, which operates in Georgia, Kazakhstan and Ukraine, Italy’s Montedison, which will be armed with a cash-filled war chest when it sells off its non-core assets, and the ubiquitous EDF.
Such companies will not find Russia an easy market, however, and will face competition from ambitious domestic generating companies and oil companies such as Yukos and Lukoil. Yukos has particularly ambitious plans, aiming to generate 13 million MWh of electricity by 2005. Like most oil companies, it is likely to do this by leveraging its own natural gas reserves and infrastructure, and may choose to partner with RAO UES. Such deals will enable RAO UES to diversify its natural gas supplies away from Gazprom.
Closing the gap
In a first step towards a more investor-oriented approach, RAO UES has devised the ‘5000 MW Plan’, a programme to develop 11 power projects in the Volga, Pskov, Nizhny Novgorod and Tyumen regions. The projects include the upgrade and expansion of existing facilities as well as the implementation of planned greenfield projects.
The 5000 MW programme will, says RAO UES, give participants hands-on experience of operating in Russia’s power sector without high risk or high capital outlay. Participants will be in a good position when privatization actually takes place, and will also be able to leverage their assets to expand in the market.
Financial models of the selected projects have been made on the basis of international investment return standards. Key projects under this programme are the North-Western, the Pskov and the Dzerzhinsk plants. RAO UES is planning to announce a tender for the North-Western project as early as June 2002.
The North-West project involves the construction of an additional 900 MW of combined cycle capacity at the site of a combined cycle plant recently completed by a consortium of Siemens, Fortum and Polar. This existing 450 MW project cost RAO UES a reported $500 million, and it is considering selling its 47 per cent stake in the plant to a strategic investor.
Russia: a sleeping giant
RAO UES is Russia’s main electricity company. It is essentially a holding company, with majority or near-majority stakes in 75 regional energos and 23 large federal power plants. It was established in 1992 and is 54 per cent owned by the Russian government. RAO UES has an installed capacity of 155.1 GW; it owns and operates about 84 per cent of the high voltage transmission grid as well as the Central Dispatching Unit (CDU).
Through its regional energos, RAO UES controls around 90 per cent of capacity and 70 per cent of the country’s thermal generation. It also controls foreign electricity trade. The energos generate, distribute and supply power in their respective regions. Mosenergo is the largest, providing electricity and heat to 4 million customers in the Moscow region. It has an installed power production capacity of 14 700 MW.
There are four regional energos operating independently of UES. Irkutskenergo is the largest of these, owning six per cent of all Russian capacity.
Nuclear generation capacity is controlled by the Ministry of Atomic Industry, which owns the Leningradskaya nuclear power plant and Rosenergoatom, the holding company that controls the country’s nine other nuclear plants. Nuclear energy capacity in Russia is around 21 GW, and this could increase to 35 GW by 2020.
The RAO UES transmission grid consists of seven regional systems, six of which are interconnected; the Far Eastern Energy System is operated independently of the other systems.