Electric Shock in Russia
Mar 23, 2007 - Business Week
Communism, Lenin once remarked, equals
Soviet power plus the electrification of the whole
country. Such was the thinking that gave rise to
Unified Energy System, Russia's vast power concern.
With 580,000 workers, 440 power stations, and 2
million miles of power lines, UES is a sprawling
empire that produces more than 70% of Russia's electricity.
With annual consumption of 980 trillion kilowatt
hours, Russia gobbles up more of the stuff than
any country in the world, except for the U.S. and
But if Lenin were alive today, he
might be in for a shock. That's because this ultimate
symbol of communism is now being broken up and sold
off, chunk-by-massive-chunk, to private investors.
The ambitious program is the largest privatization
project in Russia since the early 1990s, and also
one of the most radical electricity reforms anywhere
in the world. This year alone, UES is hoping to
raise no less than $15 billion from 15 major asset
sales. "It's a fantastic event. This is the biggest
movement of assets anywhere in the world," says
David Herne, a UES board member and managing director
of Halcyon Advisors, a consultancy advising on the
In many ways, Russia's bold electricity
reform is a surprise. In strategic sectors from
oil to aerospace, the Russian state has been expanding
its ownership and influence, and President Vladimir
Putin has increasingly moved away from the pro-market
reforms with which he flirted during the early years
of his presidency.
Paying for Crumbling Infrastructure
Yet the one big exception is electricity, where
the Kremlin seems to have been persuaded by the
radical reform arguments put forward by Anatoly
Chubais, UES's chief executive officer since 1998
and the chief architect of the plan. No stranger
to controversy, Chubais was previously a top economic
adviser to Putin's predecessor, Boris Yeltsin, spearheading
the privatization program that saw most of Russian
industry sold off in the early 1990s.
The major argument put forward by
the reform's advocates is the need to attract massive
amounts of investment -- around $100 billion between
now and 2010 -- to renovate Russia's crumbling electricity
infrastructure. Most of Russia's generating equipment
and power lines were built decades ago. Adding to
the strain is rapidly rising electricity demand,
now growing by around 5% each year on the back of
strong economic growth.
The gap between capacity and demand
is closing fast, leading to growing supply problems
that included a major power blackout that hit Moscow
in 2005, bringing much of the city to a standstill.
"Putin is intelligent enough to realize you need
this reform," says Herne.
Big Investor Appetite At the heart
of the plan is the sell-off of Russia's non-nuclear
power stations, which have all been parceled out
into 21 new power-generation companies, all but
one of which [responsible for hydroelectric power]
have been slated for privatization. The new companies
include 14 that have been organized territorially,
with power plants concentrated in particular regions
of the country, and seven with assets that are spread
out in different parts of Russia. Over the coming
months, large stakes in the new generator companies
will be sold off in open tenders.
The first such sale, on Mar. 11, was
an encouraging sign of investor appetite. OGK-3,
which operates power plants in several parts of
Russia, attracted bids from several Russian and
international companies including Gazprom, Gaz de
France, Italy's Enel, Finland's Fortum, and three
other local bidders. The winner, Russian nickel
mining giant Norilsk Nickel, paid $3.1 billion for
the 38% stake, paying a 13% premium on the current
For Norilsk, the purchase of power
assets is a useful complement to its existing mining
business, allowing it to hedge against higher energy
prices. For similar reasons, other large local corporations,
such as metals concern Russian Aluminum, are among
those now eagerly eyeing electricity assets. Meanwhile,
Gazprom, Russia's state-dominated gas concern, is
also emerging as a significant player. In a separate
deal with UES, it has recently acquired a majority
stake in Mosenergo, the electricity generator that
serves the Moscow region.
High-Efficiency Hopes The expectation
is that by bringing competition and new management
into the sector, the reform will not just attract
much-needed investment, but also promote economic
efficiency and transparency. At the moment Russia's
power sector is not exactly known for either. It
costs around twice as much to build a power plant
in Russia as it does elsewhere in the world.
"It's a very good reform. It's one
of the least efficient sectors of the Russian economy,
which will probably become one of the most efficient,"
says Alexander Branis, a UES board member and portfolio
manager for Prosperity Capital, a large equity investment
fund in Russia. He expects that as a result of privatization,
the value of Russian electricity shares will rise.
At the moment they are only worth half of what they
would be if the sector were run as efficiently as
it is in other countries.
Of course, Russia being Russia, not
everything about the reform is positive and straightforward.
"The only question is whether Gazprom will get a
lot of these assets, because they will not be run
in the best possible way in Gazprom's hands," says
Branis. Russia's large gas concern is 51% owned
by the state, and not known for low costs and efficient
management. If it ends up dominating the power sector
as well as gas, the result of the reform will simply
be to transfer assets from one large state monopoly
Low, Low Prices A related question
is how open, in practice, the forthcoming tenders
will be for foreign investors. "Clearly for Russia,
a foreign buyer would be extremely positive. It
would bring in new standards, technology, and corporate
governance," says Herne. Although several foreign
companies are showing interest, it remains to be
seen just how much money they will be willing to
put up -- and whether it will be enough to outbid
the likes of Gazprom.
One possible deterrent is uncertainty
about the future of Russia's regulated electricity
tariffs. At about three cents per kilowatt hour
for wholesale buyers, and seven cents for retail
customers, these prices only barely cover costs.
On the positive side, Russia has made significant
progress in raising prices closer to market rates
over recent years: In 2002 Russian retail consumers
paid just 1.6 cents per kilowatt hour.
Chubais has said he is very keen to
attract foreign buyers, a goal that doesn't appear
to have met serious objections. "No one in the government
is particularly concerned about preventing foreign
investors, if they are prepared to pay acceptable
prices," says Branis. So, before long, even Western
corporations may be pumping electricity to Russian
factories and homes. What would Lenin have said