Russia Makes Its Big Power Play

Sep 11 - Sunday Business; London (UK)

Russia is planning its final big privatisation, a hugely ambitious programme involving the country's entire electricity generating system. The Kremlin intends to put Russia's power plants up for auction and invest $80bn (Pounds 45bn, E65bn) over the next four years in building new generating capacity. Most of the investment will come from outside investors through initial public offerings.

Much is at stake for President Vladimir Putin. If the electricity modernisation programme goes badly, the country's blistering economic growth will falter and more lives be put at risk by winter power cuts. If it goes well, it could turn into a bonanza for foreign investors and investment bankers in London and New York.

The programme will accelerate this week when Anatoly Chubais, chief executive of Russia's state-owned utilities company United Energy Systems (UES), sets off on his fifth roadshow to woo foreign investors.

He will begin his trip in New York before moving on to Stockholm and then London. Chubais had already pocketed $1bn of promises before leaving and Italian utilities company Enel added promises of another $2.5bn-$5bn of investment on Friday. "In terms of big plays, Russia is the final frontier," Enel chief executive Fulvio Conti said on Friday.

Chubais is a man in a hurry: demand for electricity-generated power is poised to outstrip capacity and Russia's national electricity grid is already overloaded in the most populous regions including Moscow and St Petersburg.

Chubais is no stranger to privatisations. As Russia's leading "young reformer" he masterminded the country's much criticised "voucher privatisation" under former President Boris Yeltsin in the early 1990s. The voucher programme transformed the Soviet command economy into a market oriented one. It also saw the emergence of fabulously wealthy Russian oligarchs while the majority of Russians, who were issued with vouchers and sold them on thinking they were valueless, gained little from the largely corrupt programme.

Top investment bankers are queuing to meet Chubais. International investment banks made a mint from the voucher privatisation. Among the western investment banks Chubais will meet are Credit Suisse, Morgan Stanley, Merrill Lynch, Goldman Sachs and Deutsche Bank. Several are already big minority investors in UES, which is one of Russia's best blue-chip stocks.

The company originally approved a four-year $79bn investment programme in July that would quintuple its current annual investment. The plan is to have the extra generating capacity by 2010. The investment will be funded by selling shares in perhaps up to 20 newly created generation companies.

The start of reforms to attract this investment into the power sector comes not a moment too soon. In May, the city grid was overloaded as local power stations failed to keep up with spiking demand.

For years, Chubais has been warning of the danger of a power crisis, but the Moscow blackout shocked the Kremlin into action and put long-mooted power sector reform on top of the political agenda.

After six years of blistering economic growth, Russia's power stations are struggling to keep up. Today, nearly half Russia's Soviet-built power stations have exceeded their useful working life and the grid is regularly threatened with overloads.

"The situation is very acute not only in one, two or three regions, but in tens of regions," Chubais told Putin at a meeting two weeks ago. "For us, this means tough work under the threat of accidents and blackouts."

UES says it needs to invest at least $5bn a year. So far it has only been able to scrape up at most $1bn a year. Under the new investment programme UES will spend 462bn rubles ($17.3bn) over the next four years on new generating capacity with the state contributing only $1.6bn.

Dmitri Bulgakov, a utilities analyst with Deutsche UFG bank in Moscow, says: "The big question now is how to raise the money to prop up the new (generating) companies as the asset base is deteriorating. The power sector has had hardly any investment for at least a decade."

Unlike other "strategic" sectors, particularly oil, the Kremlin intends to open the power sector to anyone with big money to invest. Putin went out of his way to say foreign investors would be welcome to invest in, and own, Russian power stations.

After several false starts, work on rebuilding the sector began in earnest last year and has gone remarkably smoothly. Soviet central planners set up about 70 integrated power companies, known as "energos", that did everything from generating electricity to delivering it to apartment blocks in effect a series of regional monopolies. The trick has been to restructure the power business to introduce some competition and so create markets in electricity.

Over the past year the energos have been broken up and their generating units reformed into 20 generating companies, dubbed "gencos".

Putin's ultimate goal is to liquidate the state-owned UES, which has been the holding company for all of Russia's power assets, and hand over control of the generating facilities to private investors.

In addition to the gencos, the distribution functions have been reorganised into a series of distribution companies (dubbed "discos"), a separate holding company called HydroOGK for the hydropower plants, a systems operator and a grid operator (FSK) that ultimately will be the only thing the state will retain control over.

Deutsche UFG's Bulgakov says: "UES used to hold stakes in some 72 regional energos, which were vertically integrated companies that did everything from generate the power to distributing it. The issue is how to introduce competition into this market you need to separate the generation, transmission and distribution companies or else people will abuse the market."

The key feature of the reform is the new gencos will issue shares that will be offered to investors to raise the tens of billions of dollars needed for building new generating plants. Unusually, Chubais claims the Kremlin is happy to see its stake in these gencos diluted to 25% in the process. Even this blocking stake will be sold to strategic investors further down the privatisation road, with the state retaining strategic control by keeping control of the distribution grid.

The first initial public offering (IPO) of a genco, called OGK- 5, is slated for November, with another four gencos going under the gavel in the following months. The consolidation of OGK-5's assets was completed in April after four power stations were merged to form the company and it is already producing accounts meeting international standards.

Investors are lining up. Russian industrial holding Interros, owned by oligarch Vladimir Potanin, has already bought 5% of OGK-5 and is negotiating with the regional authorities to buy out the rest during the IPO.

Interros is going head-to-head with Enel, which has also expressed an interested in OGK-5. The Italian company has been aggressively expanding in central and eastern Europe and has big plans for Russia.

Several other big Russian companies will also bid up the prices. Most of Russia's oligarchs have significant shares in UES, which provides the lifeblood to their factories and mines. And the state- owned gas monopolist Gazprom is the biggest single shareholder in UES with 11.6%; Gazprom wants to see efficiency improved at power stations, 60% of which burn gas, to free up more gas for the lucrative export markets.

The IPO of OGK-5 will be the first test for Putin's power reforms. UES has not set the sell-off mechanism in stone, and is using this IPO to test the water as much as to raise money. Bulgakov says: "UES has suggested it will reduce its stake to 25% but there is no rule. The placements will depend on market conditions as well as the interest of potential investors both portfolio and strategic. It is these things that will determine the size and manner of the sales."

Chubais has been called "the most hated man in Russia" as the 1990s privatisation process plunged nearly the entire population into poverty, except for a super-rich oligarch class that snapped up the state's most valuable assets for pennies.

UES is determined to avoid the same mistakes. Independent consultant Deloitte & Touche was brought in to value the assets before going ahead with the swaps and mergers that created the gencos. UES also made sure the accounting firm's methodology was widely published so bank analysts could pick over the details and make sure nothing fishy was going on. UES also hired several investment banks to give a "fairness opinion" on the swap ratios.

However, having private ownership of power stations will make no difference unless there is a market in which to sell power. The Kremlin put this last piece of the puzzle into place on 1 September when it started to increase the amount of power utilities that can sell on the nascent unregulated electricity exchange.

Currently power tariffs are set by a government committee. The government has deliberately held down increases as part of its drive to control inflation. This policy has stifled investment.

A trial wholesale market was set up six years ago and utilities allowed to sell a small part of their output at prices set by the market. Chubais hailed this month's decision to start raising the quota by up to 15% a year as a "new era" for the power sector. "This is the kind of decision that moves the country forward," Chubais said.

However, analysts have said the change is too little too late as it remains unclear just how long it will take for full price liberalisation. The official government plan says it will take from five to 15 years to have completely free prices; Chubais has been telling bankers that prices will be completely free by 2009, according to reports.

Just in case price growth is slow, the government has added a sweetener to make sure they find the investment: the Duma, Russia's parliament, approved an investment guarantee mechanism that means if prices don't rise as expected investors can claim compensation.

With demand outstripping new capacity growth for several years, consumers will also be protected from the inevitable "price spikes" by government subsidies for the first few years, says Chubais.

Investors have always been tempted by Russia's power sector as the assets are among the few massively undervalued companies left. But they have been constantly frustrated by unfulfilled promises of reform.

UES was Russia's bell-wether stock before the 1998 crisis, attracting billions of dollars of foreign portfolio investment. Investors lost nearly everything in the 1998 financial crisis, but many of them have hung on to their stock. Now comes the pay off: UES stock has already tripled in value in the past year as it became increasingly clear the reforms would happen.