Russian Electricity Restructuring

Ocober 18, 2006, Ken Silverstein, EnergyBiz Insider

Russia's electricity consumption is growing at a 5.3 percent rate. While that is in some part indicative of a growing economy, it is also presenting problems as it relates to the current restructuring of the electricity sector.

The goal of liberalization is to attract foreign investment and to rebuild the nation's energy infrastructure. Nuclear generators there must be replaced within 10 years, all to enable the nation to achieve its state objective of doubling its nuclear output by 2020.

The transmission system, meanwhile, has been in decline since the fall of the Soviet Union. But, the democratic process is starting to take root and the economy has been perking up. It's a challenge, although the good news is that Western nations may now have more of an appetite for investment in Russia.

Basically, restructuring involves the privatization of RAO Unified Energy System (UES). The company now comprises 72 percent of the installed capacity, 69 percent of power production and 71 percent of customer sales, all in Russia.

RAO UES is now being split into separate generation, transmission and distribution companies. At this time, the government's stake in the state-owned power company is 53 percent. By 2008, however, all non-nuclear plants and all regional distribution systems will be privatized. Meanwhile, the transmission system will remain government-owned and tightly regulated while no single private owner can control more than 35 percent of generating capacity in any price zone.

At a recent conference in Moscow, RAO UES CEO Anatoly Chubais said that electricity supplies to multiple regions of Russia including Moscow and St. Petersburg will soon be restricted. Russian power generators may not have the ability to meet this coming winter demand and the company may therefore have to import electricity from such countries as Ukraine, Kazakhstan and Lithuania.

"The task is to provide the domestic Russian market with electricity, which will probably mean in practice, for the first time in the company's existence, a move from pure exports to pure imports," says Chubais. "And at the same time, we, of course, have to observe all our contracts, all our commitments to international suppliers. We value the reputation of a reliable partner and will maintain it."

The strain on the current electricity infrastructure in Russia means that foreign investment is urgent. RAO UES has promised to auction its assets in a competitive and transparent manner. Several nations have expressed an interest in acquiring minority shares of generators. Chubais, for example, has met with the brass at ENEL, Italy's largest power company. Top officials at both companies discussed Russia's final stage of electricity reform and the forthcoming re-organization of the Russian behemoth.

Open Doors

The economic doors are open. Russia has reformed its banking systems and recognized capital-driven regulations that would attract market participants. It is also rich with natural resources and has enterprises with investment grade ratings. Clearly, the government there will continue to play an integral role. But, its policies are evolving and allowing for private and foreign ownership in major energy enterprises.

Russia comes to the "West with reasonably open arms," says Greg Vojak, partner in Bracewell & Patterson's Kazakhstan office. "One of the most important things for any company seeking to do business in the former Soviet Union is to look for a good partner." American rules and regulations, by comparison, may have fewer financial impediments that would detract investors. And, for better or worse, those laws are replete with environmental hurdles that can add years of expense, he adds.

No one underestimates the difficulties in restructuring. State subsidized electric prices have not only led to improvidence but it has also rendered RAO UES unable to recover its costs tied to infrastructure and equipment. Estimates are that $100 billion is needed to bring the power structure there up to speed -- something which the private sector is thought best suited to provide.

At the same time, the country is wary about selling off state-owned assets and especially to foreigners, having been burned in the mid-1990s by similar sales that let a few oligopolies run much of Russia's industry. Meanwhile, Western nations have had mixed results when it comes to deregulation, leading skeptics to question whether Russia's newly-formed democratic institutions can master such a colossal feat.

But the choice to restructure and to allow more private participation is unavoidable, albeit the approach to achieving that goal must be prudent. Restricted foreign investment is expected to result in electricity output shortfalls this winter. Those constraints are anticipated to last until the infrastructure there gets a facelift. Moreover, fresh thinking would usher in new internal processes and systems, all of which would help alleviate the inefficiencies that have produced waste within the organization.

"We believe that ... monopolistic intermediaries have long outlived their usefulness," says Andrei Trapeznikov, a board member of RAO UES. Investors that come to the table early in the process, he says, can play an integral role in helping to shape the outlook of the power industry in Russia. Beside ENEL, Electricite de France and E.ON of Germany are expressing interest in the Russian electricity sector.

The difficulty in attracting investors to a nascent industry with highly subsidized prices and no concrete path to fully operational open markets is readily apparent. If power producers were to recapture their costs and earn fair returns, prices would likely jump as much as 200 percent -- an unlikely scenario, given the social instability it would cause. In fact, prices for consumers are expected to remain regulated until 2008 while low-income residents will receive additional protections.

Russia's investment climate has been harsh. But, the country knows better than to rush headlong into restructuring. A reasoned process that motivates foreign investors while maintaining domestic stability is a good approach. The country needs to increase the efficiencies of both its grid and power plants and can only modernize by opening its borders to the West.