Investment in Russia: SUPERPOWER OPPORTUNITIES?
February 1, 2003
By Branko Terzic and James Balaschak
The Russian power sector is priming itself for outside financial and infrastructure investment. By Branko Terzic and James Balaschak
Prospects for the successful development of the Russian power sector in the next 20 years will depend on the inflow of private investment into the industry. The crucial task, as clearly understood by both the Russian government and the management of the major power companies, is how to significantly raise the attractiveness of the industry to private investors.
The current state of the power sector of Russia can be characterized by:
- A high concentration in monopoly, with one organizational structure uniting recognized monopoly functions (transmission and distribution) and potentially competitive activities (generation and sales);
- An absence of free markets (both wholesale and retail) for power and generating capacities;
- State regulation of power tariffs, with a tendency for tariff growth rates to lag behind the general inflation index;
- Low profitability of electric power and heat production due to low regulated tariffs and low efficiency. Regulator-set tariffs do not compensate for investment risk;
- Incompleteness of legal frameworks within the developing market environment; and
- A low expectation of required private investment (both direct and portfolio).
Restructuring: A Vehicle To Increase Russia's Potential for Investment
Early in 2003, the parliament of Russia, the Duma, is considering a package of five bills that could result in the largest restructuring of an electric industry since the break-up of the U.S. electric holding companies in the 1930s. The proposed legislation follows earlier large-scale reform and restructuring that began in the summer of 2001 in the Russian power sector. Of the five Russian bills, the electricity bill is the most important. The proposed bill sets up the legal framework for regulation of the wholesale and retail electric sectors, establishes clear government authority to regulate, and specifies the rights of parties engaged in the generation, transmission, and purchase of electricity. The purpose of these dramatic changes in the Russian electric sector is to increase the efficiency and attractiveness of the Russian electric power sector to domestic and international investors.
The vision of the Russian electric industry in the proposed legislation closely follows reforms introduced in Western Europe, parts of Latin America, and in parts of the United States. The successful reform of the Russian electric sector would result in the creation of a competitive, economically viable, privately financed electric power generation sector; establishment of a single national grid operator; and the creation of financially competitive regional electric distribution companies. The Russian plan envisions competitive wholesale markets in power generation, regulated tariffs for transmission and distribution, and eventual consumer access to competitive power generation at retail.
Part of this restructuring plan, submitted to the Russian government in November 2001 by the dominant Russian electric holding company, Joint Stock Company Unified Electric System of Russia (RAO UES), calls for the establishment of 10 generation companies (owning 48 key power plants), a national grid, and a trading system operator.
The Russian GDP is projected to grow between 3.2 percent and 5.5 percent per year until 2020, with increasing domestic power consumption rates of 1.7 percent to 3 percent per year. The growth, coupled with the retirement of aging power plants, will require new power plant construction. Total investment needs in the Russian electric power and heat networks are estimated to exceed $147 billion by the year 2020. The proposed restructuring plan accepts the principle that private capital can be made available to meet these needs if regulatory and investment conditions are made attractive to domestic and foreign investors.
The Dominant Monopolies
Reformation of the Russian power sector must begin with the restructuring and unbundling of the RAO UES, currently the largest power monopoly in the world. Its role in the Russian electric industry is crucial, and the proposed reforms have been initiated by policies surrounding its future.
The electric power sector is a basic industry in the Russian economy, serving both the internal needs of the domestic economy as well as exporting electricity. Thermal, hydroelectric, and nuclear power plants produce Russia's total installed electric capacity of approximately 214 million kW.
The total length of Russia's electric transmission lines, of all voltage classes, is 2.5 million km, of which 150,000 km are 220 kV to 1,150 kV networks.
The RAO UES owns more than 90 percent of the electric transmission system and covers all of the inhabited territory of the country, from its western borders to the far east. The size of this electric transmission grid makes it one of the largest centrally managed utilities in the world.
About two-thirds of power production in Russia comes from thermal power stations, 19 percent from hydroelectric stations, and 14 percent from nuclear power stations. Unconventional renewable sources of energy are quite insignificant-less than 0.1 percent.
Distribution of power generation in Russia by fuel source used is shown in Figure 2.
Figure 3 shows the distribution of the installed generating capacity between the above companies as of the beginning of 2000.
The RAO UES, RosenergoAtom, and AO-Energos
The RAO UES was established in 1992 as an open joint stock company, with shares traded on the public exchanges. Owned by the Russian government, the holding company has a controlling stake in 72 regional energy supply companies, the AO-Energos, and 32 large power plants, making RAO UES the leading player in the Russian power sector. The company owns 71.1 percent of all hydro and 86.9 percent of all thermal Russian power generation. It owns 96.3 percent of all electric transmission and functions as the central dispatcher for the country.
The regional electric companies are part of the RAO UES structure, and the federal power stations are formally independent joint stock companies. As such, they prepare their own balance sheets and income statements. However, RAO UES strongly oversees their production and financial activities.
In addition to actively trading shares of RAO UES, Russia's capital markets also trade shares of the largest AO-Energos included in the RAO UES holding. Large-scale reform and restructuring processes initiated in RAO UES in the summer of 2001 are due to be completed by 2008.
In the nuclear sector, RosenergoAtom was established in 1992 and charged with centralized state management of nine of the 10 nuclear power stations of Russia. This includes 26 power generation units with 18.2 million kW of total installed capacity. Rosenergo-Atom is a state company subordinate to the Ministry of Atomic Energy. The Leningrad Nuclear Power Plant is an independent operator (four units with 4 million kW of total installed capacity) and is directly subordinate to the Russian Ministry of Atomic Energy.
These nuclear power stations, located in the nodes of the network and determining the structure of high-voltage transmission lines in the European part of Russia, are the backbone of the energy system of Russia. Nuclear power plants participate in the seasonal regulation of both frequency and capacity of RAO UES, providing reliable and sustainable operations for the country's power system. Nuclear power generation facilities in Russia are expected to remain under state ownership for the foreseeable future, and an estimated 35.8 million kW of new generation capacity will be installed at existing nuclear plants by 2020. Private investments are not expected to be allowed in this sector.
Irkutskenergo has the most potential of the four independent AO-Energos. It operates 12.9 million kW of generating capacity (or 6 percent of all Russian capacity), including 9 million kW of hydro power station capacity (or 20 percent of all Russian capacity), and 33,000 km of transmission lines (1.3 percent of all Russian lines). The cost of power generated by Irkutskenergo is the lowest in Russia (due to the high proportion of hydro electric power capacity).
Although organizationally independent from RAO UES, the AO-Energos (as well as the nuclear power stations) depend on RAO UES technologically, as the principal backbone transmission lines are owned by the holding and the Central Dispatch Control Board of the Unified Energy System of Russia is a structural subdivision of RAO UES. The administrator of the federal wholesale power and capacity market (FOREM) is also a subsidiary of RAO UES.
The Business Case for Investment
Electricity production in Russia declined significantly in the 1990s because of the financial crisis and the subsequent slowdown of demand. However, since 1999 consumption has been growing slightly.
According to world power sector development forecasts, world power demand is expected to grow at a rate nearly equal to the growth rate of the gross domestic product (GDP), averaging an annual 3 percent until 2020. Thus, Russian energy strategy guidelines, approved by the government, contain two scenarios for changes in power demand from 2001 through to 2020, depending on the forecasted average annual GDP growth rates: "favorable" (GDP grows by 5 to 5.5 percent annually) and "reduced" (GDP grows by 3.2 to 3.5 percent). Under the "reduced" scenario, domestic power consumption over the period to 2020 will grow annually by an average 1.7 percent (about 50 percent of the GDP growth), whereas under the "favorable" scenario, power consumption will grow by 3 percent (about 55 percent of the GDP growth).
The expected levels of domestic power demand, under the various scenarios of Russian economic development, are illustrated in Figure 4. It should be noted that under the reducedscenario of economic development, power consumption growth in Russia will be materially lower than world average, while under the favorable scenario, growth will be at the average world level.
The expected growth in power consumption until 2020 and the high levels of power generating capacity retirement expected during the period will require significant construction of generating capacity to compensate. The forecasted levels of generating capacity retirement due to physical obsolescence are illustrated in Figure 5, P. 30.
By 2020 the total retirement of generating capacity will exceed 163 million kW, or about 75 percent of the installed capacities as of January 2001. The level of new capacity needed to compensate for the retirement of equipment and to meet the growing demand is illustrated in Figure 6.
Total construction of generating capacity during the period 2001 to 2020 is estimated to be 231 million kW.
Figure 7 shows the estimated investment needed to realize the forecast (including new transmission lines and heating network) corresponding to the "reduced" scenario of Russia's economic development.
Under the "favorable" scenario of economic development, the necessary investment in the power sector would increase to $271 billion over 20 years.
There are limited possibilities to raise such a large investment either internally through companies operating in the industry (primarily RAO UES and its subsidiaries), or through special financing from the state budget of the Russian Federation. In the 1990s, due to privatization of the industry (excluding the nuclear power sector), capital investment from the state budget virtually ceased to exist. Financing through power companies' own funds accounted for no more that one-tenth of the estimated investment needed.
The legislative package being reviewed by the Duma during early 2003 contains all the essential elements necessary to begin the transformation process for the Russian power sector. This includes a new regulatory law, which clearly establishesregulatory principles and grants federal regulators the necessary authority to be able to assure investors and Russian consumers of fair treatment.
Russian regulators have recognized the need to introduce regulatory schemes that treat both consumers and investors fairly. An April 2, 2002, document (No. 226) titled "Foundations of Price Formation" embodies attractive and workable cost-of-service type pricing methodology for electric tariff setting. This document follows long-established and proven U.S. regulatory practices of regulation to provide for recovery of reasonable costs of service, including recognition of fair return on current investment at rates determined by capital markets. These kinds of principles in the hands of regulators newly empowered by the proposed electricity bill will create the opportunity for a very attractive investment environment in Russia.
International investors and Russia's domestic investors will be offered significant opportunities for large-scale private investment in the Russian electric power industry over the next four to five years; in addition, some opportunities for financing independent power projects are already available and required to meet near-term needs. There is every expectation that some workable version of the currently proposed legislation will be successfully implemented into law by the Duma and thus create the conditions for an electric industry capable of supporting Russia's vast potential for economic growth in the 21st century.
Branko Terzic is director in the Energy Resources Group of Deloitte & Touche LLC in Washington, D.C. He also serves as regional managing partner for the Resources, Energy & Infrastructure Practice Group of Deloitte & Touche Central Europe. Terzic is a former FERC, Wisconsin PSC commissioner, and CEO of Yankee Energy Systems. Reach him at: bterzic@deloitte.com.
James Balaschak, based in Moscow, is the partner in-charge, management consulting, Deloitte Touche Russia.
Russia: Restructuring in Three Phases
The restructuring of the the Russian power sector is planned in three stages lasting from 2003 to 2008.
The First Stage of Power Sector Reform (2002-2004):
- Preparing and adopting essential legal and statutory acts (the electricity bill and four companion bills currently under review by the Duma) regulating activity in the power sector under market conditions, including the development of rules governing the functioning of a competitive wholesale power market, and the creation of mechanisms for equal access to the grid infrastructure for market participants;
- Creating a single vertical system regulating monopolistic activity in the sector;
- Beginning RAO UES restructuring by separating the federal grid company (future owner of all backbone transmission lines), the system operator (which will perform all the commercial dispatch functions) and nine to 10 large generating companies from the main structure;
- Forming a single generating company, consisting of 10 nuclear power plants;
- Setting up the Trade System Administrator as a non-profit organization, founded by the main participants of the emerging wholesale power market;
- Organizing a settlement system for the power supply market;
- Transitioning electric power retailers to a commercial dispatch system appropriate to their needs and requirements; and
- Setting up a single nuclear generating company on the basis of 10 nuclear power plants.
The new grid operator, JSC System Operator-Central Dispatch, was established in May 2002 as a 100 percent subsidiary of UES with a board made up of UES, government, and minority shareholder representatives. The operator will establish seven regional branches. Full unbundling is scheduled for 2004.
As early as the first stage of reforms, up to 15 percent of the generated electric power will be sold on the free market at prices regulated by the market.
Introducing the Second Stage of Reform (2004-2006):
Introducing rules governing the competitive wholesale power market, definition of procedures for interaction between participants;
Creating independent supply companies;
Uniting the federal grid company with the system operator (if expedient).
By the end of the second stage of reform, all electricity generated must be sold on the competitive wholesale market. The state regulation of tariffs for electric power generation and sales will end. The state will only regulate monopolistic activities-including the transmission of electricity via backbone transmission lines and commercial dispatch.
The Third Stage of Reform (2006-2008)
The third stage, which completes the restructuring, is key in terms of providing investment opportunities for the Russian power industry. At this stage, all conditions, both economic and organizational, must be created, to attract investment by way of large-scale sale of shares in generating companies and in other companies performing competitive activities. There also will be an increase of the state share in companies performing monopolistic activities-the federal grid company and system operator.
Wholesale Generating Companies: The New Players
Wholesale generating companies, emerging as a result of RAO UES restructuring, are due to become the target for investment in the long term. As many as 11 generating companies are planned: six owning thermal power plants, four that exclusively operate hydroelectric power stations, and one nuclear power station operator. RAO UES has submitted to the Russian government a list of power plants to be merged in the formation of generating companies. The following criteria have been used for competitive thermoelectric generating companies:
- Prevention of the merger into one generating company of price-dominating power stations located in the same price zone;
- Limitation of power generation market concentration;
- Balanced distribution of total installed capacity of power stations between generating companies;
- General balance of distribution of the age of generation capacities.
The creation of wholesale generating companies is scheduled to be completed by 2004.
- B.T. and J.B.
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