Christopher De Vere Walker, DVW Group, UK
Two years ago, I wrote an article for PEi, “Buy the rumour, sell the fact” (passim, May 2007), citing that the Russian power sector would succumb to a bearish reality if the market uncertainties where not resolved quickly. More importantly, perhaps, I expressed the critical need for power companies to develop solid corporate governance in conjunction with an intelligent structure to handle the new market realities.
Russia’s Territorial Generating Companies (TGKs). Source: DVW Group
My rationale was based on my own trading experiences coupled with comparisons to Russia’s Western peers.
As with all rumours, the hype surrounding the power sector was contagious, so few people expressed my point of view publicly. Failure to restructure the sector successfully could have cost many consultants hefty bonuses and the top management of the generating companies their so-called “golden parachutes”, i.e. bonuses worth millions of dollars for selling off the shares of the generating assets to the investors. Privately, at least, many knew it was a time bomb.
While the market architects would prefer to blame the global economic crisis for the sharp decline in the companies’ market value (up to 90 per cent loss) the truth is that the forced restructuring was driven by the belief of an improved infrastructure and a guaranteed return on investment. Instead, the ownership of the newly acquired assets became a burden to the investors, who in reality had scant means to recoup their investment.
The concept of Russian reforms
As a result of the reforms, the Russian power sector was divided into competitive (generation and sales) and regulated (power transmission) segments, both formally, on the legislative level, and by the forms of ownership and business practices. The power generation was divided up into territorial generating companies (TGK), wholesale generating companies (OGK), independents and state owned entities.
Furthermore, sales companies were spun off from the gencos. All generation and sales companies are theoretically within the competitive space. Naturally, the federal grid company, as well as the distribution company, trade administrator and system operator, remain within state control and are non-competitive.
As a result of the reforms, the state and semi-state owned companies dominate the competitive segment. Such companies as RusHydro and Rosenergoatom together control about 24 per cent of Russia’s installed capacity. The state owned Gazprom controls about 21 per cent of Russia’s thermal generation. While the affect of the state’s dominance is not immediately visible, it could become more obvious as the balance between the regulated and non-regulated segments of the market reaches 50/50 per cent on June 1, 2009.
The reforms in practice
It would be easy but counterproductive to criticize the Russian power market. Deregulation was an immense challenge. With a 2007 consumption of 1003 billion kWh (ranked third in the world) few could disagree about the size of the market and hence the size of the prize. Before the crisis, there was a real fear that demand would quickly outstrip supply. Rampant demand verses aging equipment meant that a capacity market was needed to ensure both availability and new build.
Russia’s Wholesale Generating Companies (OGKs). Source: DVW Group
The drive for attracting the investment through the sale of thermal generation has been the most impressive. The market architects managed to attract an impressive 1 trillion roubles ($29bn) into thermal generation. In addition to the Russian strategic investors (IES, SUEK, UC RUSAL, Norilsk Nikel, Onexim, Russian RailRoad, ESN, Sintez, Lukoil, E4 Group), generating assets were acquired by such foreign operators as E.ON, Enel and Fortum.
The market architects have created the framework of the market structure that in many aspects resembles those of the Europe and the United States. The Day-Ahead Market (DAM) and Balancing Market (BM) provide for the marketplace to trade electricity. However, the current Russian power market reveals that the market is still developing the basic structures and tools that allow for flexibility in hedging risks.
However, the positive aspects of liberalization are unable to compensate the expenses related to the fuel and operating costs for the generators, when the low fixed tariffs represent 65 per cent to 70 per cent of the current market. In 2008, the 12 per cent growth of electricity tariffs could not match the 25 per cent growth of gas prices and 20 per cent growth of coal prices.
In addition, the state regulation of tariffs for the residential consumers, representing 13 per cent of Russia’s demand, resulted in the imbalance between the growth of residential tariff and the growth of expenses for generation. As a result, in 2008 the tariff growth for the residential consumers was limited to 16.7 per cent while the expenses of the generators increased by 21 per cent. Thus, the shrinking spark-spreads and the dark-spreads coupled with the growing inflation (no less than 16 per cent) presented a direct threat to the companies’ profitability.
In DVW Group’s investigation of the Russian power market, we mapped out the market structure, the players, the practices and procedures in action, and the routes to market it became obvious that the market building process in Russia has been like a track being built in front of a moving train. The train has now caught up.
A good example is the ambitious investment programme for the construction of 29 GW of new capacity by 2015. However, our investigation demonstrated that the location of the new build has never been linked to the actual needs of the regions but rather has been used as an expensive entry ticket for the investors. Moreover, should the investor fail to put the capacity on line such company would face a 25 per cent penalty of the total cost of the investment programme.
The capacity market, which has been thought of as a mechanism of recouping the investments, unfortunately is still dysfunctional. In addition, the Federal Antimonopoly Service (FAS) has established a division on control over the prices by the generating companies to prevent price manipulation at the wholesale market. Thus, irrespective of the investment needs, the generators would be unable to raise the power prices above the norms that have been established by FAS.
For some investors this decision already represents an obvious restriction in the investment activity. In addition, the figures of the falling demand in the five consecutive months (November 08 March 09) demonstrate that out of 180 GW of Russia’s available capacity the real demand is around 100 GW. Today the natural move for the government is to allow the review of the investment programmes both from the point of view of real demand, regulation and terms of commencement. The potential restructuring of the investment programmes will enable the companies to re-direct the financing to meet their current needs and short-term liabilities.
Too many chiefs
It is all too easy to create a monster when trying to create a power market, particularly the case when banks, consultants and lawyers are involved. Many times, I witnessed a nondescript consultant who lacked practical credentials at the former gates of RAO UES. The most important questions are as follows. Is the market transparent? Is it easy to access? Is it a level playing field to all users? Do I have any mechanisms to hedge my risks?
Let us begin with the geography. This is potentially the most difficult part of the problem in creating a power market in Russia. The market architects decided to opt for a nodal model as practiced in many parts of the United States. Russia’s grid has much in common with the United States and so little additional thinking was needed when adopting this model. Typically, the nodal model, unlike the zonal model, reflect transmission constraints more accurately by pricing congestion from each plant.
Therefore each plant normally reflects an actual node. This means that each of the pricing hubs in Russia is a reflection of the equilibrium price of each node, and not an actual traded price. There are six hubs, four in the European zone and two in the Siberian zone. Outside of these zones, the market remains regulated for the time being. Therefore companies with assets within the pricing zones work within the market rules.
A power market mechanism needs to be kept as simple and as transparent as possible. At present this is still an issue. Market participants need easier market access to hedge their risk. The intraday and day ahead markets need to be cleared like an exchange where in the current situation the payment mechanism is becoming more like a lottery.
Contracts further out, such as weeks, months and years ahead need to be simply financial. The Free Bilateral Agreement (Russia’s forward agreement) is barely traded and is still a clumsy forward instrument. Naturally, the overriding problem is credit risk. Which counterparty can you trust? In the days before the credit crunch, credit risk was then a big concern.
Today this problem has been magnified, giving stronger arguments for an exchange mechanism similar to NordPool. Unfortunately the NordPool model is very unlikely to work in Russia because few financial institutes could support the size of risk involved with clearing Russian power trades.
Situation critical: Russia’s Power grid
The wear and tear of Russia’s grid infrastructure, as per our estimates, on average is 65-70 per cent (in some regions 80 per cent). The need in the grid capacity is unsatisfied. The investment programme of the Federal Grid Company is the largest in the segment. However, the government, being the sole owner of this strategic infrastructure, is unable to develop and finance the grid’s needs at the expense of the current grid tariffs.
The natural solution to attract private investors fails in the face of non-transparent regulation and high risks. As a result, the market architects once again decided to turn to foreign experience, this time borrowing a British model of tariff regulation. Until 2011, all distribution companies are to adopt a new model of tariff regulation, the regulated asset base (RAB), based on the return on the invested capital. The government believes that the new system of RAB tariff regulation will decrease the investment risks by providing transparent mechanisms of guaranteeing the investment and capital yield.
By suggesting the yield on invested capital of 12 per cent the market architects understand that the distribution and grid companies will have to attract financing at much less interest and for a longer term. However, the current cost of debt in the market for a regional distribution company (MRSK) is 25-30 per cent, so while the new method would make grid investment attractive, it is not practical until the financial markets recover.
By 2011, however, the power market liberalization should be over, with 100 per cent electricity tradable at market prices. However, the government has already confirmed that it would not liberalize the power prices for the residential consumers. Our research shows that this represents about 13 per cent of the sector. In addition, the Minister of Economic Development of the Russian Federation declared on 22 March 2009 that the Government would consider introducing a new price regulation for all liberalized markets, inclusive of the power market.
The decision is driven by the Government’s intention to halt inflation and its effect on the economy of Russia. The potential price regulation of the liberalized segment of the power market could further decrease the profitability of power companies unless the government price-caps the prices for gas and transport tariffs, since both drive the expenses for the gas fired and coal fired power plants.
The need for power remains critical
Despite the negative impact on the development of Russia’s power sector, this is the time when the market architects have the opportunity to review the original concepts and adjust the mistakes that have been made under the pressure of frightening shortage in supply.
During the next year or two, Sovet Rynka and the Ministry of Energy, the two bodies essential for the approval of further steps in the market development, are to take critical decisions that would allow the power sector to become transparent, investment friendly and stable, for both generators and consumers.
In this period, the power sector being a strategic one is likely to enjoy governmental protection, both from the point of view of preferential financing and semi-favourable regulation. The Government of Russia has worked out the formula of correlation between the growth of power consumption and the growth of GDP.
They believe that 1 per cent GDP growth increases the power consumption by 0.3 per cent. Following the formula the anticipated GDP growth in Russia of 3.5 per cent in 2009 still would envisage the power production growth by 1.05 per cent in 2009.
The specifics of the Russian power industry are still in long-term planning. Market architects will have to plan for the times when consumption growth returns to the pre-credit crunch level of 4-5 per cent per annum. The need for qualified operators, EPC contractors and practitioners remains as critical as ever.