Moscow tightens its grip on the power sector

Jeremy Bowden

Sochinskaya, one of Russia’s earliest modern combined-cycle power plants, which is now being extended for the 2014 Winter OlympicsSource: Siemens

The opening of Russia’s power sector is sliding into reverse as state corporate giants expand, while government failure to implement promised reforms makes further private investment increasingly unlikely.

Across many sectors of the Russian economy, Russian state conglomerates are on the advance.

The approaching presidential election appears to be accelerating a four-year trend of rolling back liberalising reforms, helping to re-establish the power and central role of state giants.

The power sector has seen a halt to further promised reforms, causing investment to stall. Some private investors are looking for a way out, and state corporations are proving to be willing buyers.

“Every industry where there is potential to earn healthy returns is now a target for the state enterprises,” said Alina Bakhareva, Russian-speaking analyst on energy and power markets at Frost & Sullivan.

Last July, Russia’s natural gas giant Gazprom and IES Holding, which is owned by Kremlin-friendly Viktor Vekselberg, agreed to merge the Renova power group with Gazprom’s generating assets. Although Russia had said it wants to continue the privatisation process by selling off the state distribution holding company, MRKH, it has separately been mopping up privatised generators via Inter RAO, a state-controlled electricity trader created during privatisation.

“To make assets profitable in this environment, operators must be experienced. Those who know how to work the system are the old state corporations, which are reconsolidating their positions,” said Bakhareva. Together, Inter RAO, Gazprom and other nuclear and hydro state-owned generators control more than 70 per cent of the generating market, putting the system in de-facto state control.

Gazprom alone already owns power companies that control 36 GW of capacity, producing 17 per cent of Russia’s electricity. In addition to the planned merger with Renova, it has been gradually consolidating its various power assets, including a 2011 merger of two of the six privatised wholesale generating groups (OGKs) in which it had a majority stake. The proposed Renova/Gazprom power group would have a total generation capacity of 52 GW, or an impressive quarter of the domestic market. The firms are pressing ahead despite the concerns of Russia’s FAS Antimonopoly Commission.

Vassily Savin, the Head of Power and Utilities sector in Transaction & Restructuring at KPMG Russia & CIS, believes that because of the current uncertainty in the power and utility sector new private investors may prefer to cancel or postpone investments in the sector, while David Weavering of Renaisance Capital believes private equity in distribution and transmission companies may already be ready to exit.

But Savin cautions that political interference is common in power sectors worldwide, citing the example of E.ON’s hit from nuclear closures in Germany due to the government decision post Fukushima accident.

Most analysts agree that existing overseas investment in generation is still profitable and will remain. “Companies like Enel and E.ON, as well as domestic investors, can make money on depreciated assets, but building new plant is another matter,” said Aleksandar Kovacevic, an independent consultant.

Christopher de Vere Walker, Russian power specialist at IHS-CERA, agrees, suggesting some investors were not surprised at the state’s back-peddling on reform, and are reasonably content with the status quo. “Companies are making money, but are concerned about future moves,” he said.

Savin points out that although there is certain return on investments in the sector, private investors ” particularly in the thermal generating segment ” in the current regulatory landscape can expect to receive better return on the invested capital. In spite of current regulation environment, E.ON boosted its stake in OGK-4 from 78 per cent to 82 per cent.

The potential impact of the proposed merger with Gazprom, however, should be underestimated. Renova’s old boss, Viktor Vekselberg ” who will have a 25 per cent share in the merged entity ” said he expects the new company to save money because “it can buy natural gas cheap from Gazprom”.

This could put competitors at a substantial disadvantage, especially as Gazprom is gradually raising domestic gas prices to export levels, and upends the level playing field required to attract new investment. Recent signs of hesitation over the deal could be a “power-play” on the part of Gazprom, which may prefer Renova to take higher gas prices than to go through with the merger, says Bakhareva.

But the Russian government’s failure to adopt promised price reform is still seen by analysts as private investors’ biggest concern, rather than unfair competition from state corporations.

Political Hot Potato

The government had committed to deregulate energy prices for larger consumers altogether in 2011. Faced with inflation fears, the state failed to follow through on this promise and also capped rises in household electricity tariffs to just 15 per cent for the year. Putin even delayed the implementation of the rise from January to July 2012 ” a popular move designed to win support ahead of Russia’s March elections. In response, the heads of Enel, E.ON and Fortum’s Russian divisions wrote an open letter to Putin last year calling for a reconsideration of the tariff cap and complaining about inconsistent regulation.

De Vere Walker points out that the political sensitivity of the sector is proving the greatest threat to foreign investment returns, rather than the large state entities that dominate the market. In fact, all generators ” including overseas investors ” benefit from the pressure that large organisations such as Gazprom can put on policymakers, he says. This is because there is relatively little direct competition between generators in the market ” Russian grid load averages 47 per cent compared with 65 per cent in Europe ” so all incumbents tend to benefit from alterations that only the large state organisations can achieve.

Russians are accustomed to cheap power and heating. If faced with excessively steep rises, they will find ways to dodge or modify their electricity bills, while communal Soviet-era architecture makes it almost impossible to disconnect consumers, according to Bakhareva. Politicians are exposed to heavy lobbying in Russia’s Duma by many vested interests, including the influential Council of Consumers pressure group ” although residential consumption represents just 20 per cent of the market and pressure also comes from large employers and industries reliant on cheap energy.

Russian industry is at least twice as energy intensive as industry in the European Union, and export-earning industries such as oil and gas and metal refining require vast quantities of cheap power. Modern oil extraction techniques, such as steam injection, are particularly greedy in this respect, notes de Vere Walker.

Wholesale power prices actually rose by only 12 per cent in European Russia in 2011, and by 11 per cent in the Siberian market area, while average levels varied greatly between regions ” being more than 70 per cent higher in European Russia than on the Siberian grid ” according to de Vere Walker. A huge difference between wholesale prices and end-user prices results from distribution grids’ ownership structures and their poor state and operation. But Russian electricity bills are still among the lowest in Europe at about $9/MWh, compared with a European Union median of $185/MWh.

The reform of Russia’s power sector had been at the heart of President Medvedev’s modernisation agenda, but last year he said higher oil and gas prices should not be used as an excuse to hike power tariffs, and that rising electricity prices had become a real threat to economic growth. Nevertheless, analysts still agree that Putin’s anticipated resumption at the reins of power, rather than a continuation of Medvedev rule, is negative for further private investment in the sector.

Slow Car Crash Scenario

The lack of investment is raising concern over increasingly frequent accidents and power outages similar to the Moscow blackouts at the end of 2010, which hit airports and the city, causing chaos and rioting as flights were suspended and thousands were without power.

Other examples include the 2009 disaster at the Sayano-Shushenskaya hydroelectric power station that killed 75 people, and the blackout that left 40 per cent of St Petersburg without power in August 2010. Industry experts say higher electricity prices are essential to stimulate investment in Russia’s aged power plants and prevent a collapse of the system. De Vere Walker estimates Russia needs between $550 billion and $800 billion in power sector investment over the next 25 years.

Daniel Wolfe, deputy general director of Quadro, one of the territorial generating companies spun off from the electric power holding company RAO UES, recently warned that if the government fails to keep its side of the bargain to allow electricity and heat prices to rise, power and heat outages will be increasingly likely. The government is currently prioritising low bills over ensuring the consumer has a reliable, safe supply of electricity, and only reacts when there is a catastrophe, according to a senior manager of one of the generating companies.

De Vere Walker suggests a “slow car crash scenario” may be on the horizon, as investment is increasingly squeezed out by the overwhelming need to restrain price rises. Kovacevic points out that as the state corporations re-absorb more of the sector they are also taking on more capacity and investment commitments, which they are unlikely to prioritise. Gazprom, for example, has many profitable contending projects competing for scarce funds both at home and increasingly overseas, while it continues to suffer from under-investment in its core gas production and transmission assets. Even when the investment is made, it takes longer and is more inefficient than similar investment per megawatt in the European Union he added.

Nevertheless, Kovacevic notes that there continues to be a steady flow of private capital into private distributed generation from hotels and condominiums, as well as businesses primarily motivated by the need for security of supply or cogeneration opportunities. He and Frost’s Bakhareva also see some opportunities for companies to make money from efficiency improvements, given the rundown and badly operated state of the system. Access to international best practice can be the advantage required, adds Bakhareva.

Overall, Russia’s RTS Electric Utilities Index fell from 274 in January 2011 to 204 on 6 February 2012 ” down by more than 25 per cent. The worst performer in the index was distribution holding group MRSK, whose share price halved as a result of the government’s price cap. Some investment funds have fared even worse, such as EOS Russia, a distribution-heavy Stockholm-based fund set up in 2007, which has lost 80 per cent since its launch.

Yet there are recent signs that the potential for post-election tariff reform is luring back some funds, including Russia’s biggest fund, Prosperity Capital Management and Germany’s Wermuth Asset Management.

Concern among analysts over Russia’s backtracking on privatisation and liberalisation in the electricity sector is well placed, not just because of the impact on their clients. If Russia’s leadership makes investment too unattractive, it may be condemning the power sector to many more years of stagnation and neglect. This will undermine attempts to stimulate the country’s developing small and medium-sized business sector aimed at modernising the economy and reducing its dependence on oil, gas and other raw material giants.

Moreover, state champions like Gazprom are not up to doing the job alone. Now burdened with more and more obligations to invest, Gazprom recently complained in a press release that additional revenues from a 15 per cent gas price rise in July 2011 will meet less than half the additional domestic gas-related taxes it will be required to pay in 2012, leaving less in the pot ” and less incentive ” for gas and power development at home.

If the Kremlin truly believes that Russia’s particular strengths are better suited to a more statist approach, it should make sure funds are available along with correct structures and incentives for companies like Gazprom to invest domestically and operate efficiently. Otherwise, with state giants unchallenged and unfettered in their home markets, and focused primarily on profitable exports and overseas ventures, it is the Russian people who will pay the price in the long run.

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