Can Russian reforms boost investor confidence?

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Russia’s unbundling of its monopolistic power sector and the deregulation of power prices have been without doubt impressive feats. However, will the market mechanisms, such as the long-term capacity market and financial derivatives market, due to be introduced this year have the desired effect of building much-needed investor confidence?

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Christopher de Vere Walker, DVW Group, UK

No matter how impressive the unbundling of the state monopoly and the deregulation of power prices has been to date, 2010 will turn out be the most pivotal year for the Russian power sector’s transition.

This year, the market mechanisms essential to complement the existing infrastructure will be introduced by the Kremlin. The 2010 ‘to-do list’ features the launch of the system services market, the finalization of the long-term capacity market and the launch of the financial derivatives market. Add to the list of great expectations is the emission trading scheme ratified by prime minister Vladimir Putin in late 2009.

As with all liberalized power markets, the success or failure of Russia’s market will hinge on the ability of the market participants to build up investor confidence to use the new mechanisms to hedge risks.

But will there be enough trading confidence to bring much needed liquidity and transparency to the market? Trading confidence depends on available information and data.

While Putin expects 20 GW of generating capacity to be brought online by 2012, it will take a properly functioning market to encourage this investment. The original plan obliging investors to build new capacity is constantly being questioned by investors. While they cite poor economic conditions for backtracking, the Kremlin remains firm that new capacity must come online irrespective of a slowdown in natural consumption.

Weighing into the argument has been mixed supply and demand figures. Power consumption in 2009 reached 942.8 billion kWh ” a decline of 4.7 per cent compared to 2008. However, Q4 2009 consumption increased over Q4 2008, despite no perceivable recovery in the economy, as colder weather compensated for any decline in demand.

Russia’s quarterly electricity consumption, 2006-2009.

Putin is correct that the construction of capacity should not be postponed; however, a different issue is whether power price signals will be allowed to decide where investment should be channelled.

If so, it would be contrary to the formerly state-owned utility RAO UES’ controversial planning. Unfortunately, old capacity is to slave away for another three to four years. The Kremlin knows it cannot lose precious time because the system will struggle and possibly fail when demand picks up.

Fears of a dysfunctional capacity market, or inadequate guarantee mechanisms, or price-capping (flattening) already plague confidence.

It is a classic ‘carrot and stick’ problem. A power market with reliable price signals would be the ‘carrot’ for the investors, but the Kremlin is more familiar with using the ‘stick’.

Therefore the new owners insist the liberalization process must stay its course, without being derailed, for a chance to achieve adequate return.

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POWER PRICE INDEX

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The complexity of the Russian power market makes future prices and volatility difficult to assess. Firstly, the liberalized sector has two pricing zones, European and Siberian. The European zone has 8000 nodes out of which there are four hubs and the Siberian zone has 602 nodes with two hubs.

Gas fired power plants dominate the European zone. The majority of Russia’s nuclear power plants are located in the western part of Russia’s border. There are also some hydropower plants running up the River Volga.

As an example, in the third week of 2010, the share of thermal production reached 72.98 per cent, the share of hydropower generation was 6.51 per cent and the share of nuclear generation was 20.51 per cent.

The make-up of generation is quite different in Siberia, where the thermal power plants are mainly coal fired. It also has a much higher dependence on hydropower, with some of the world’s largest hydro facilities in this zone. As an example, in the third week of 2010, the share of hydro production was 32.97 per cent, while the share of thermal power plants’ generation reached 67.03 per cent.

Russia’s liberalized power sector is divided into two pricing zones ” European and Siberian ” and six hubs

In the summer, when many of the heat and power plants are undergoing maintenance, the share of hydropower can reach 70 per cent, with the share of thermal generation dropping to below 30 per cent.

This summer however, will be different because of the Sayano Shushinskaya hydropower plant explosion last August. The accident resulted in a loss of 6400 MW, causing a price spike of 800 roubles ($26.50) in the balancing market.

The increasing level of liberalization in Russia’s wholesale power market

At that point, Vasily Zubakin, then chairman of the board of RusHydro, and the owner of Sayano Shushinskaya, complained about the unfairness of liberalization because RusHydro was heavily penalized for being out of balance.

This eventually enforced the real argument that hedging mechanisms to protect physical players against financial distress should be introduced without further delay. Furthermore, the accident brought forward the need for a system services market, for both the producer and the consumer. Another ramification of the accident was further worry that the pro-regulation lobby would drag the market backwards.

A leaning towards regulation or price caps will naturally encourage asset owners and large sales companies to continue with inefficient methodologies, thus harming the medium-term prospects for the sector.

Today in the wholesale market, 40 per cent of the electric power is sold at tariff via regulated agreements, which unintentionally play the role of a long-term hedge. Up to now the only other instrument to hedge the power price risk has been the forward free bilateral agreement for power and capacity.

With that, the contract’s volume is limited to the physical power that should be either consumed or produced. The sellers are only generators, the risk of non-payment is high and the price is not close to a market price. Furthermore, should the price fluctuate by more than 20 per cent, the market participant either faces additional tax charges or price-flattening mechanisms.

There is an absence of liquidity because in the situation of an unfavourable power price movement at the spot market (day-ahead market) there is no possibility to sign the reverse deal in order to hedge a contract or position.

On the retail level, when signing a long-term fixed price power purchase agreement with the end-user, the sales company ” a guaranteed supplier ” will face the price risk when the contract price differs from the spot prices. As a result, all price fluctuations on liberalized volumes and much of price risk are passed on to end-users.

The issue is further complicated by consumers’ cash deficit resulting in constantly increasing liabilities to the market, currently standing at 74.4 billion roubles.

With high volatility already present in the power market and the synthetic hedge of regulation slipping away, the players need a liquid and transparent market place to hedge.

While fuel prices are relatively static, they are now rising, along with transportation costs. This should cause an upward trend in power prices, perhaps to a point where Finland may sell power back to Russia for the first time.

As per the Kremlin’s energy plan, regulated gas prices from Gazprom have more than doubled in six months, placing significant pressure on the spark spread.

Rising gas costs in Russia have increased demand for independent producers such as TNK-BP, Itera and Lukoil, which often means better utilization of associated gas. Naturally, the positive ramifications are a drive towards more diversity of suppliers, which was not thought likely five years ago.

Gazprom could even show signs of fragmentation in two to three years if pricing pressure continues. If gas is traded on an exchange as per the Kremlin’s wish, it will only serve the market better and allow power producers to hedge fuel risk more effectively.

It may perhaps soon give rise to tolling agreements and spark spreads as one product. In this case, victory will favour the innovative and prepared companies.

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POWER EXCHANGE & PRICE HEDGING

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A long-standing unresolved issue in Russia has been the absence of commodity exchanges for the key industries, resulting in the lack of market price formation for key commodities, such as gas, oil , coal, metals, grains and sugar.

There have been attempts to create such marketplaces by trading financial contracts for the price difference at Russia’s stock exchange, RTS, however due to the non-existence of a physical market it has been more of a virtual game.

The availability of the wholesale power and capacity spot market represents an ideal opportunity for a derivatives power market to be launched. The rise of the power exchange will have far reaching consequences as its tentacles will grab other commodities and products, and players find the benefits of hedging and trading.

Sharing similar characteristics to EEX and Nord Pool in Europe and PJM in the USA, the goal of Russia’s power exchange, called ‘Arena,’ is to provide the power market participants ” primarily utilities and large retail consumers ” with the tools to hedge the growing price risk.

Up to now, Arena has been offering the participants of the wholesale power market, ‘WE&CM’, to trade capacity and power under physical forward agreements.

However, just ten per cent of the wholesale power market participants chose to hedge their positions by signing either OTC (over-the-counter) free bilateral power purchase agreements, or forward agreements at Arena. The liquidity is low due to accounting issues related to signing of such contracts.

But with the launch of the futures, Arena hopes to attract new players by easing the problems associated with access to market. Following Russian legislation, there is no restriction with regards to the companies’ capital when it comes to trading at the commodities exchange.

In addition, as long as a company has the licence of an exchange intermediary (i.e. broker) by the financial markets regulator FSFR, it will be granted access to trading futures at Arena. Alternatively, any company or individual will be able to trade via accredited brokers.

While the exchange is of primary interest to the power sector companies as well as to the equity portfolio managing companies, which have been allowed to keep part of their portfolio in derivatives on commodities, Arena hopes that market volatility and transparency will also attract speculators.

The recent launch of trial futures trading confirmed enormous interest from the market participants. With 160 companies and 425 traders registering for the trial (simulation) trading, Arena may hold the answer to Putin’s much-needed ‘carrot’.

Although we expect significant liquidity created by the physical players, we envisage a considerable pick-up in volumes when the speculators start trading at Arena. This would be in a year to 18 months after the launch of the power futures market.

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A STEP IN THE RIGHT DIRECTION

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The last few years have seen a magnificent transformation of probably the most complicated power system in the world. While rules and regulations have often played catch up, they at least move to accommodate the market players, albeit to some extremes.

Without doubt, there is much ground to cover, but this market is still young. Therefore, we should encourage the promulgation of these important new processes for 2010.

It feels like the right direction, and frankly, it is better to start these journeys than to ignore the possibility of their existence, not to mention their importance. These changes are much needed to complement the market allowing the participants across the board to extract value from their Russian assets.

DVW Group is a leading independent power sector specialist with a focus on Russia and the CIS. The company examines the latest market trends with detailed analysis on energy trading. It also provides clients with weekly Russian power and fuel briefs, power sector reports, and workshops.

DVW’s western clients most commonly engage it to identify a route to market, investigate indigenous companies, look for strategic partnerships and investments, or pure fact finding

Its Russian clients primarily engage DVW to support their ongoing strategic planning to extract better value from their assets in a changing market environment.

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