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A critical juncture for Russian power

The Russian power industry will require massive levels of capital investment if the country is to avoid an impending electricity crisis. Three years ago the Russian government unveiled a reform programme designed to drag its largely state owned energy enterprises into the 21st century in order to attract vital foreign investment into the sector. Marian Hagler, Peter O'Driscoll and Robert Wagner of Coudert Brothers discuss whether it is too little, too late.

Facing major electricity shortages, Russia has embarked on important new efforts to attract capital to the sector, including restructuring the national utility, offers of shares in existing generators, tariff liberalization and licensing reform to permit new types of competitors. However, significant obstacles remain.

Status of the Sector

The Russian power and gas sectors have traditionally been considered "natural  monopolies" and remain under state control, although some initial share privatization has occurred. RAO Unified Energy Systems of Russia (UES) controls over 80% of all Russian power generation directly and through companies called "Energos" that are responsible for generation and distribution of power in a particular region. A separate state company controls nuclear plants which produce 15% of Russian electricity. In addition, UES owns and operates the national grid, and controls exports of non-nuclear electricity from Russia.

Wholesale and retail tariffs are controlled by the Federal Energy Commission (the "FEC") and its regional subdivisions, ("regional energy commissions"), which are responsible, among other functions, for establishing retail tariffs. The FEC is supposed to control retail tariffs through these regional energy commissions. In addition, a wholly-owned subsidiary of UES, ZAO TsDR FOREM (FOREM), operates the wholesale electricity market. Energos and certain large consumers may sell excess electricity to, and purchase additional electricity from, FOREM based on contracts with FEC-approved prices.

Gazprom, the state natural gas company, controls essentially all natural gas. Seventy percent of all Russian power generation is thermal, and over 42% of all Russian power generation facilities are gas-fired. As a natural monopoly, Gazprom (like UES) is subject to price controls established by the FEC.

Despite recent increases, prices remain at levels that are well below the world market. Because suppliers have only a limited right to cut off non-paying customers, the rate of non-payment by customers is high. The process for setting and collecting tariffs is politicized. 

Crisis and Reform Efforts  

Analysts estimate that between US$30 to US$60 billion of capital investment in the power sector will be required to avert acute electricity shortages within the next five years. Since the power sector obtains natural gas and other feedstock at below-market prices, there has been little incentive to modernize generation facilities. Moreover, tariff restrictions and collection problems have left the sector strapped for cash.

The "July 2001 Strategy" put forth by the Government to reform the electric power sector stems from the Government's general economic "Action Plan" of 2000 (see below).

The July 2001 Strategy sets forth general principles and guidelines, but lacks specifics as to how certain reforms will be implemented. It contemplates reform in three distinct stages, over an 8 - 10 year period, and envisages many legislative and regulatory changes. The July 2001 Strategy contemplates a new electric power and energy law as well as amendments to the Civil Code, the Law on Natural Monopolies and the Law on State Regulation of Tariffs on Electricity and Heat Energy in the Russian Federation (the Tariff Law), and other laws and regulations.

Restructuring

In accordance with the July 2001 Strategy, electricity generation facilities of UES and the Energos are to be organized into eight to ten large "GenCos" by January, 2003. Eventually, UES will sell down its holdings in these GenCos. In the meantime, UES is reported to be in talks with at least 15 foreign power companies with respect to investment in generation upgrades. Most significantly, in November 2001, UES pitched to investors 12 new projects as components of a "5000 MW" program, focused principally on completing or upgrading generation facilities.

It is not yet clear at what point in the sell-down the GenCos might be considered to be "IPPs" and therefore eligible to sell all of their electricity to FOREM at any price, in advance of complete tariff liberalization at the end of Stage II. Clearly, decisions to invest in GenCos will turn on how this is clarified. Moreover, as far as creating the cornerstone to competition, the large size of the GenCos, and their ability to dominate regional power markets may create difficulties for any potential IPPs.

As a first step toward the decoupling of UES control of transmission and distribution, the Federal Transmission Company (the FTC) was established to own all existing main (trunk) transmission lines. It will also acquire the main transmission lines currently owned by the Energos. The July 2001 Strategy contemplates that the shares of the FTC will be distributed gradually to the Government during Stage III (i.e., by 2006/2007). The activities of the FTC will be regulated as a natural monopoly, and transmission tariffs will be set by an authorized state agency (presumably, the FEC) on a cost-plus basis.

The system operator has also been established initially as a UES subsidiary, with gradual sale of shares of the system operator to the Government during Stage III. What seems to be lacking in the July 2001 Strategy is a focus on the regulatory scheme to which the FTC and the system operator will be subject.

Tariffs and Wholesale Market Reform

The July 2001 Strategy permits the gradual increase of electricity tariffs. In addition, as an immediate step, all IPPs will be free to sell their production to FOREM at any price. (The definition of IPP remains in need of clarification however.) To provide incentives for non-IPPs to increase their sales to FOREM, under the July 2001 Strategy, non-IPPs will be free to sell (during Stage I) 5 to 15% of their power to FOREM at any price, and up to 100% by 2006/2007.

During the first phase of Stage I (i.e., by January 2003), a wholesale market administrator will be organized as a non-commercial organization independent of UES and the Government to operate the wholesale exchange and administer electricity trading. Also during the first phase of Stage I, rules will be established to govern wholesale trading. Access to the wholesale market will be granted to any buyer or seller who can meet the minimum trading volume requirements and otherwise complies with such rules. The July 2001 Strategy envisions some liberalization beginning immediately and complete liberalization by 2006/2007.

The July 2001 Strategy contemplates the maintenance of state controls on retail tariffs through the end of Stage I (July 2004). Retail prices will be freed from state controls during Stage II (i.e., by 2006/2007) when IPP generation is expected to dominate the market. At that point, it is hoped, controls would remain only on the remaining "natural monopolies", i.e., transmission and dispatch.

 A CRITICAL JUNCTURE FOR RUSSIAN POWER - WILL RUSSIA IMPLEMENT THE REFORMS NECESSARY TO ATTRACT INVESTMENT IN A KEY SECTOR?

By Marian Hagler, Peter O'Driscoll and Roger Wagner

Facing major electricity shortages, Russia has embarked on important new efforts to attract capital to the sector, including restructuring the national utility, offers of shares in existing generators, tariff liberalization and licensing reform to permit new types of competitors. However, significant obstacles remain.

Status of the Sector

The Russian power and gas sectors have traditionally been considered "natural  monopolies" and remain under state control, although some initial share privatization has occurred. RAO Unified Energy Systems of Russia (UES) controls over 80% of all Russian power generation directly and through companies called "Energos" that are responsible for generation and distribution of power in a particular region. A separate state company controls nuclear plants which produce 15% of Russian electricity. In addition, UES owns and operates the national grid, and controls exports of non-nuclear electricity from Russia.

Wholesale and retail tariffs are controlled by the Federal Energy Commission (the "FEC") and its regional subdivisions, ("regional energy commissions"), which are responsible, among other functions, for establishing retail tariffs. The FEC is supposed to control retail tariffs through these regional energy commissions. In addition, a wholly-owned subsidiary of UES, ZAO TsDR FOREM (FOREM), operates the wholesale electricity market. Energos and certain large consumers may sell excess electricity to, and purchase additional electricity from, FOREM based on contracts with FEC-approved prices.

Gazprom, the state natural gas company, controls essentially all natural gas. Seventy percent of all Russian power generation is thermal, and over 42% of all Russian power generation facilities are gas-fired. As a natural monopoly, Gazprom (like UES) is subject to price controls established by the FEC.

Despite recent increases, prices remain at levels that are well below the world market. Because suppliers have only a limited right to cut off non-paying customers, the rate of non-payment by customers is high. The process for setting and collecting tariffs is politicized. 

Crisis and Reform Efforts  

Analysts estimate that between US$30 to US$60 billion of capital investment in the power sector will be required to avert acute electricity shortages within the next five years. Since the power sector obtains natural gas and other feedstock at below-market prices, there has been little incentive to modernize generation facilities. Moreover, tariff restrictions and collection problems have left the sector strapped for cash.

The "July 2001 Strategy" put forth by the Government to reform the electric power sector stems from the Government's general economic "Action Plan" of 2000 (see below).

The July 2001 Strategy sets forth general principles and guidelines, but lacks specifics as to how certain reforms will be implemented. It contemplates reform in three distinct stages, over an 8 - 10 year period, and envisages many legislative and regulatory changes. The July 2001 Strategy contemplates a new electric power and energy law as well as amendments to the Civil Code, the Law on Natural Monopolies and the Law on State Regulation of Tariffs on Electricity and Heat Energy in the Russian Federation (the Tariff Law), and other laws and regulations.

Restructuring

In accordance with the July 2001 Strategy, electricity generation facilities of UES and the Energos are to be organized into eight to ten large "GenCos" by January, 2003. Eventually, UES will sell down its holdings in these GenCos. In the meantime, UES is reported to be in talks with at least 15 foreign power companies with respect to investment in generation upgrades. Most significantly, in November 2001, UES pitched to investors 12 new projects as components of a "5000 MW" program, focused principally on completing or upgrading generation facilities.

It is not yet clear at what point in the sell-down the GenCos might be considered to be "IPPs" and therefore eligible to sell all of their electricity to FOREM at any price, in advance of complete tariff liberalization at the end of Stage II. Clearly, decisions to invest in GenCos will turn on how this is clarified. Moreover, as far as creating the cornerstone to competition, the large size of the GenCos, and their ability to dominate regional power markets may create difficulties for any potential IPPs.

As a first step toward the decoupling of UES control of transmission and distribution, the Federal Transmission Company (the FTC) was established to own all existing main (trunk) transmission lines. It will also acquire the main transmission lines currently owned by the Energos. The July 2001 Strategy contemplates that the shares of the FTC will be distributed gradually to the Government during Stage III (i.e., by 2006/2007). The activities of the FTC will be regulated as a natural monopoly, and transmission tariffs will be set by an authorized state agency (presumably, the FEC) on a cost-plus basis.

The system operator has also been established initially as a UES subsidiary, with gradual sale of shares of the system operator to the Government during Stage III. What seems to be lacking in the July 2001 Strategy is a focus on the regulatory scheme to which the FTC and the system operator will be subject.

Tariffs and Wholesale Market Reform

The July 2001 Strategy permits the gradual increase of electricity tariffs. In addition, as an immediate step, all IPPs will be free to sell their production to FOREM at any price. (The definition of IPP remains in need of clarification however.) To provide incentives for non-IPPs to increase their sales to FOREM, under the July 2001 Strategy, non-IPPs will be free to sell (during Stage I) 5 to 15% of their power to FOREM at any price, and up to 100% by 2006/2007.

During the first phase of Stage I (i.e., by January 2003), a wholesale market administrator will be organized as a non-commercial organization independent of UES and the Government to operate the wholesale exchange and administer electricity trading. Also during the first phase of Stage I, rules will be established to govern wholesale trading. Access to the wholesale market will be granted to any buyer or seller who can meet the minimum trading volume requirements and otherwise complies with such rules. The July 2001 Strategy envisions some liberalization beginning immediately and complete liberalization by 2006/2007.

The July 2001 Strategy contemplates the maintenance of state controls on retail tariffs through the end of Stage I (July 2004). Retail prices will be freed from state controls during Stage II (i.e., by 2006/2007) when IPP generation is expected to dominate the market. At that point, it is hoped, controls would remain only on the remaining "natural monopolies", i.e., transmission and dispatch.

Licensing

Licensing requirements for electricity production and sales activities have been reduced, but remain in need of clarification. The July 2001 Strategy proposed, without explanation, that "transfer", "distribution" and "dispatch" will be activities subject to licensing. However, under a new licensing law enacted shortly after the July 2001 Strategy was announced, licenses are to be issued for "electricity production" and "network operation" by the Ministry of Energy. The law specifically excludes captive or inside-the-fence facilities that produce power for a company's own use. The new law does not clearly address whether IPPs will be licensed, but suggests that wholesale power sales, sales to distributors and sales to a discreet number of end users will not be subject to licensing.

Exports

Exports of electricity from Russia offer a potential source of hard currency revenues. Two of the "blocs" of generating plants offered by UES for foreign investment have potential for cross-border sales; the Northwest bloc is already synchronized with the Finnish grid and could sell into the Scandinavian powerpool (Nordpool). However, exports must overcome a number of obstacles. Technical limitations on delivery into the EU grid require major new investments. EU conditions for reciprocal market access and environmental anti-dumping and anti-subsidy concerns will need to be met. And cheap exports may be undermined by, or may undermine, the increase in domestic tariffs for fast electricity. Russian power exports could significantly undercut European supplier prices, even at present levels of Russian inefficiency, due principally to state-mandated restrictions on natural gas prices.

However, exporting power to Europe in significant quantities will require significant infrastructure build-out. Lack of synchronization of systems is a principal hurdle to Russia's ability to export power beyond the former Soviet Union. Compatibility may be established either by building direct current links at export points, or by engaging in mass synchronization of Russian generating systems.

Conclusion

The July 2001 Strategy is well-intentioned, and makes efforts to address the monopoly and subsidy issues which currently afflict the Russian power sector. It remains unclear whether such measures will be sufficient to attract foreign investment in the power sector. There are significant questions as to whether the Government and the Duma will have the political will to propose and adopt the necessary legislation and other measures.

Related reforms need to be implemented with regard to fuel and foreign investment. In addition, foreign investors will need assurance that restrictions on foreign investment in Russian power companies formerly in federal ownership will not apply. Finally, export policies need to be considered in relation to changing domestic policies; exports of cheap electricity could play a destructive role, particularly if they have a negative effect on Russia's relationship with the EU.

To create a free and efficient power market that will attract the equity and debt financing the sector requires, Russia will need to move quickly beyond the July 2001 Strategy and remove tariff restrictions and constraints on foreign investment, abolish the monopolies that currently exist in generation, distribution, transmission and gas supply, create a transparent and fair regulatory framework and encourage the development of privately-owned IPPs. Failure to take these steps is likely to result in the electricity shortages recently predicted by the OECD.

The Action Plan of 2000

Under the Action Plan of 2000, the following reforms were to be implemented:

· spin-off UES generation assets in preparation for sale;
· develop rules for an open wholesale market;
· permit gradual tariff liberalization;
· allow wholesale marketing of output by independent power producers (IPPs);
· encourage non-IPPs to also sell power in the wholesale market ;
· permit buyers and sellers to enter into forward electricity sales contracts;
· establish a separate company to own UES's transmission assets;
· establish an independent system operator to dispatch all market participants; and
· provide for the sale of UES' interests in the Energos' distribution assets.

Marian Hagler and Roger Wagner are partners in the Washington DC office. Peter O'Driscoll is a partner in the London Office of Coudert Brothers. They advise on acquisitions and other investments in the energy sector in Russia and the CIS.

Licensing requirements for electricity production and sales activities have been reduced, but remain in need of clarification. The July 2001 Strategy proposed, without explanation, that "transfer", "distribution" and "dispatch" will be activities subject to licensing. However, under a new licensing law enacted shortly after the July 2001 Strategy was announced, licenses are to be issued for "electricity production" and "network operation" by the Ministry of Energy. The law specifically excludes captive or inside-the-fence facilities that produce power for a company's own use. The new law does not clearly address whether IPPs will be licensed, but suggests that wholesale power sales, sales to distributors and sales to a discreet number of end users will not be subject to licensing.

Exports

Exports of electricity from Russia offer a potential source of hard currency revenues. Two of the "blocs" of generating plants offered by UES for foreign investment have potential for cross-border sales; the Northwest bloc is already synchronized with the Finnish grid and could sell into the Scandinavian powerpool (Nordpool). However, exports must overcome a number of obstacles. Technical limitations on delivery into the EU grid require major new investments. EU conditions for reciprocal market access and environmental anti-dumping and anti-subsidy concerns will need to be met. And cheap exports may be undermined by, or may undermine, the increase in domestic tariffs for fast electricity. Russian power exports could significantly undercut European supplier prices, even at present levels of Russian inefficiency, due principally to state-mandated restrictions on natural gas prices.

However, exporting power to Europe in significant quantities will require significant infrastructure build-out. Lack of synchronization of systems is a principal hurdle to Russia's ability to export power beyond the former Soviet Union. Compatibility may be established either by building direct current links at export points, or by engaging in mass synchronization of Russian generating systems.

Conclusion

The July 2001 Strategy is well-intentioned, and makes efforts to address the monopoly and subsidy issues which currently afflict the Russian power sector. It remains unclear whether such measures will be sufficient to attract foreign investment in the power sector. There are significant questions as to whether the Government and the Duma will have the political will to propose and adopt the necessary legislation and other measures.

Related reforms need to be implemented with regard to fuel and foreign investment. In addition, foreign investors will need assurance that restrictions on foreign investment in Russian power companies formerly in federal ownership will not apply. Finally, export policies need to be considered in relation to changing domestic policies; exports of cheap electricity could play a destructive role, particularly if they have a negative effect on Russia's relationship with the EU.

To create a free and efficient power market that will attract the equity and debt financing the sector requires, Russia will need to move quickly beyond the July 2001 Strategy and remove tariff restrictions and constraints on foreign investment, abolish the monopolies that currently exist in generation, distribution, transmission and gas supply, create a transparent and fair regulatory framework and encourage the development of privately-owned IPPs. Failure to take these steps is likely to result in the electricity shortages recently predicted by the OECD.

The Action Plan of 2000

Under the Action Plan of 2000, the following reforms were to be implemented:

· spin-off UES generation assets in preparation for sale;
· develop rules for an open wholesale market;
· permit gradual tariff liberalization;
· allow wholesale marketing of output by independent power producers (IPPs);
· encourage non-IPPs to also sell power in the wholesale market ;
· permit buyers and sellers to enter into forward electricity sales contracts;
· establish a separate company to own UES's transmission assets;
· establish an independent system operator to dispatch all market participants; and
· provide for the sale of UES' interests in the Energos' distribution assets.

Marian Hagler and Roger Wagner are partners in the Washington DC office. Peter O'Driscoll is a partner in the London Office of Coudert Brothers. They advise on acquisitions and other investments in the energy sector in Russia and the CIS.