KEY ISSUES IN RUSSIAN POWER SECTOR INVESTMENTS

 

by Mayra Rodriguez Valladares

 

Currently, most Russian power sector analysts and bankers remain neutral to bearish on the power sector. Cash collection rates, although improved over the last quarter, remain relatively low by Western standards. Also, with upcoming parliamentary and presidential elections, officials are not focusing on necessary reforms in the power sector. Despite the weakness of the sector, now is a good time for U.S. investors to conduct significant due diligence on the Russian electricity sector, which is the country=s second largest in terms of market capitalization and daily trading volumes. Investors need to approach the Russian Ministry of Fuel and Energy, United Energy Systems (UES), and the regional utility companies (energos) if they are interested in electricity sector investments. Also since regional governors exert significant influence on companies, particularly utility companies, in their regions, visits to regional governors and their staff are an important part of the due diligence process.

 

One key for any investor contemplating investments in the Russian power sector is to understand the sector=s reform process as it is currently being undertaken.

 

The Status of Reforms

Despite talk about reform, the power sector has not been restructured or privatized. Generating, distributing, and transmission assets have not been separated. The United Power Grid of Russia, which is the world=s largest power pool with centralized management, is one of the most controversial aspects of the Russian power sector, since it is controlled by UES. UES has stakes in most of the country=s regional utility companies, and it establishes the prices at which these utility companies can buy and sell electricity from the grid, posing a significant conflict of interest. Also, industrial customers are not able to buy directly from the grid as can customers in emerging markets such as Hungary. This restriction hinders industrial customers from having a choice of electricity providers and means that there is no incentive for utility companies to compete. In addition, industry continues to subsidize consumers for their electricity use.

 

Electricity tariffs for industrial or residential users only cover about 50 percent of costs. Given that parliamentary and presidential elections will take place this year and next, respectively, tariff realignment is unlikely before 2001. It is not surprising that Russian power companies have a significant nonpayments problem, recovering anywhere from 70-80 percent of their revenues. Only between 15 and 30 percent of these revenues are in actual cash. The rest is barter, which takes the form of actual goods exchange or tax-offsets where electricity companies do not pay taxes to the government because government entities such as hospitals and schools often do not pay their electricity bills.

 

Challenges to Reform

Five major challenges exist in reforming the Russian power sector. First, the obvious, the scope and size of the sector are enormous not only because of the size of country and the extent of the networks, but also because of the great differences in fuel type capacity throughout the country. Domestic and international government officials must have great patience in instituting reforms and must be aware of the vast differences between Russia=s 89 regions.

 

Second, because the ownership of the sector is so diversified, reform becomes even more difficult. When the Russian Government began electricity reforms, the sector was already partially restructured and privatized. Most developing countries usually begin reforms by already having one fully integrated state-owned electricity monopoly and then move from there to separate distribution and generation and to privatize the whole sector.

 

Third, the nonpayment problem needs to be tackled at the source. That is, insolvent government entities and companies should be made bankrupt and their power supplies cut. This is a challenge to which the government has not risen because of the potential for political backlash. Moreover, the country would need significant funds to restructure the sector and to provide a social safety net during the reform process.

 

Fourth, from the government to the worker on the ground at a power plant, a commercial mentality needs to be encouraged. The Russian Government and even UES see UES= role in the sector as insuring stable power supply throughout Russia and investing to meet future needs, but not in maximizing the investment value of UES or of the energos. Decisions are often made without considering how the value of the sector can be increased. In essence, profit margins practically do not exist.

 

Fifth, the power sector is extremely politicized at both the national and regional level. Moreover, Gazprom has been increasing its influence by acquiring electricity assets in exchange for utilities= bad debts to the company. Because of the intertwined nature of the power sector with every facet of Russian life, whatever party or business entity that controls UES controls Russia. As such, until after the presidential elections, officials will spend their time trying to control UES and the regional utility companies, rather than reforming and improving this vital sector.

 

Mayra Rodriguez Valladares is an emerging market energy specialist and author of Reforming the Russian Electricity Market recently published by Financial Times Energy. FT Energy, tel: +44 (207) 463-8184, fax: +44 (207) 896-2121, or visit www.energy.ft.com and reference 29224C.