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Gambling on Russia

By Siàƒ¡n Green

Russia’s mammoth task of reforming its power industry is stalling in the face of tariff reform and the upcoming Parliamentary elections. PEi examines how this is likely to affect the flow of much-needed investment into the market.

The decision in December 2002 by Russia’s state Duma to delay the second reading of the electricity reform bill is a major blow to the restructuring of Russia’s power sector. Designed to attract much-needed investment to the sector, prolonged delays to the reform process could have serious consequences.

Investment flows into the power sector are partly dependent on banking reform in Russia
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The electricity bill underwent its first reading in October 2002 with little opposition. The crucial second reading, initially due to take place at the end of November, was bound to be more problematic, and is now likely to take place in early 2003.

The hope among pro-reformists in Russia is that the electricity bill will undergo its third and final reading and be passed into legislation by spring 2003. This will lead the way for the break up of power monopoly Unified Energy Systems of Russia (UESR), and for the in-flow of investment to expand and upgrade the power sector’s infrastructure.

Little capital has been invested in the power sector since the break up of the Soviet Union. Installed capacity stands at just over 200 000 MW, but only around 170 000 MW is actually available. It has been estimated that around 50 per cent of the country’s fixed power assets have passed their intended productive lifetime. By 2010, around 110 000 MW of generating capacity will have reached retirement age.

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In addition, electricity demand is increasing, rising by 3.9 per cent in 2000, leading to a tightening supply balance. Anatoly Chubais, Chief Executive of UESR, has stated that the Russian power sector will not satisfy demand in 2004-2005 if investments are not made. Estimates put the required investments at $20-35 billion over the next decade.

Complex issues

But passing the bill into law will be only half the battle. Experience over the last ten years has taught many countries around the world that deregulating and liberalizing power sectors is, at best, complex and contentious, and Russia is unlikely to be any different.

Delays to the reform process are inevitable, says Scott Lamb, General Director of EPIC Advisors (Russia) Ltd. “Even when they had the basic package of laws figured out, there were several issues that had to be ‘horse-traded’ and several key issues remain wide open,” comments Lamb. One of these issues is tariff reform.

Average tariffs in Russia are 5-10 times lower than rates in Western Europe, mainly due to cheap gas supplies and subsidies. Low tariffs have hindered investment and the electricity reform bill calls for tariffs to be fully liberalized by mid-2005.

Tariff reform will help to encourage investment in the power sector, but removal of subsidies is a painful process ࢀ“ especially when parliamentary elections are less than one year away. Duma deputies will not be keen to pass unpopular legislation before the elections, and have already sought to amend the reform bill to allow parliament to control tariffs beyond 2005. “Tariff reform has the potential to upset the social balance and hit the pockets of those that will be voting in December 2003,” says Lamb.

In addition, the bill does not specify the framework under which tariff reform will take place, hence the tariff issue is likely to continue even after the bill is passed ࢀ“ possibly until after the 2004 Presidential elections.

“The reform bill is written so that there is a changeover period when neither the Federal Energy Commission nor the Economics and Trade Ministry really have the power to affect how tariffs are set in the regions, or how tariffs for inter-regional trade are set ࢀ“ this has been left with the regional energy commissions,” says Lamb. “I would be surprised if you got consensus on an appropriate mechanism that encourages an acceleration of the timetable under which tariffs are liberalized. I think it’s going to be a major issue.”

If prices are to be liberalized by 2005, the framework for that to happen needs to be in place by mid-2003, says Lamb. “You don’t go from the cross-subsidized environment to totally market-based mechanisms overnight. There is a process involved that will typically take two years.”

Natural gas

Complicating the tariff issue is reform of Russia’s natural gas industry, which is supposed to take place in parallel with electricity reform. However, the industry and political spheres surrounding the electricity and natural gas industries are very different, and natural gas reform appears to be occurring at an even slower pace than electricity reform. Gas industry restructuring would also entail tariff reform, and uncertainty over this is making it difficult to determine the level of future electricity prices.

Current indications from analysts and the government are that in the short term, electricity tariffs will rise two- or three-fold. “Rates will always be relatively low [compared with Western Europe] in Russia because of the competitive advantage of natural gas, even if gas tariffs are completely liberalized,” says Lamb. “Nevertheless, the Russian government will not propose drastically increasing tariffs right away in one big bang, and so what we are expecting is a two or three-fold increaseࢀ¦ the government is hinting that it would be comfortable supporting this level of increase.”

The uncertainty over tariffs is creating uncertainty for investors such as E.ON and Electricitàƒ© de France, who are keen to develop their presence in the reforming Russian power industry.

“If you had a steady stream of investment coming in to upgrade these very depreciated facilities and restore some kind of continuity and reliability ࢀ“ especially in regions which really need it, i.e. those with the really cold winters ࢀ“ then you would probably have a more favourable environment for eliminating all the cross-subsidies in the tariffs,” states Lamb. “However, for the investment to come in, investors have to be convinced that there is a tariff programme in place.

“So it’s a Catch 22 ࢀ“ you need one before the other and the investors are trying to figure out whether they can move ahead on a tentative basis and whether the noises they are hearing about real structural reform are going to happen.”

Banking on change

But investment in the Russian power sector is dependent on more than just the restructuring of the market. Reform of the country’s banking sector is also crucial, according to Lamb.

Banking reform is scheduled to take place in 2003-2004 alongside reform of the electricity, gas and railway sectors. Improved and more effective banking services from local banks will become a driving factor behind meaningful flows of foreign investment into Russia. “When a large investment by a foreign company takes place in Russia, part of that investment is best handled by local banks that better understand the environment.

“It’s very hard for a foreign creditor to come in and feel comfortable with the legal environment through which they would be providing a secured loan, whereas a Russian bank would have a better understanding and a better tolerance of the risks involved. So how the banking reform takes place is very important.”

Investment pool

While foreign energy companies must examine the risks associated with investing in Russia, Russian utilities are aware of the fact that many international energy companies have scaled back investment over the past 12 months. This has resulted in a relatively small pool of potential investors compared, for example, with the number of companies that moved into Eastern Europe in the mid-late 1990s. In addition, companies are less willing to gamble on emerging markets.

However, the outlook for the Russian power sector is positive, says Lamb, who believes that the electricity reform bill will become law. “People are paying attention to Russia because it is a big market and is underdeveloped. The overall story in terms of the economy is not so bad and there is growth potential. So in spite of the problems ࢀ“ of which there are a number on a number of different levels ࢀ“ it would be too pessimistic to say that nothing will happen.”

He continues: “If other economies pick up, and if you see some attempt to not totally throw away the reform process prior to the elections, and if there is some sign of life in banking reform, then you could make the case that the investment climate in Russia is not going to be so chilly in 2003/4.”