Russia's Fix

Russia's Fix

Location: New York
Author: Ken Silverstein, EnergyBiz Insider, Editor-in-Chief
Date: Monday, December 8, 2008

Russia's electric market needs to be repaired. But hard times are getting in the way.

The current financial turmoil has left it in a state of disarray. And if the nation went ahead with plans to ease electricity subsidies and unleash market forces then prices would jump and create even more tumult. The conundrum turns away investors, who won't risk their money if prices are fixed and fair returns are elusive.

In July, shareholders of RAO Unified Energy Systems voted as planned to restructure, allowing private interests to own 45 percent of the utility while still giving the state a 52 percent stake. The mega-enterprise then splintered into a dozen smaller businesses in an effort to be lean and competitive. Price subsidies -- about 75 percent of customers' bills -- would be lifted in two stages with everyone paying market rates in 2011.

The goal is to attract outside capital. Estimates are that $100 billion is needed to bring the power structure there up to speed. The government, though, must be careful. It reasons that if it allows rates to rise too quickly, it would create economic upheaval. It is particularly true now, given the fact that Russia's currency has been severely devalued and that its stock market has been down considerably from its peak in 2007.

Russia has the potential to hunker down and let the storm pass. But if the chaos goes on for too long, it may be in trouble. Hence, it would need access to Western capital if its economy gets battered.

Electricity providers there are now squeezed. Industrial clients have been their bread and butter -- the ones who pay higher rates and the ones who pay on time. But some of them are struggling. And moreover, they are the ones who are asking the government to postpone plans to open the market. The first phase of liberalization is supposed to begin on July 1, 2009 when half of the nation's electricity production is to be sold on the free market. The balance would then be sold at competitive rates two years later.

To compound the matter, Russia's Market Council is telling news outlets that industrial demand is down by 6.3 percent from a year ago. To put it all in perspective, Russia's electricity demand has been rising by about 5 percent a year. But the council says that in 2009 it is supposed to be 2.8 percent for the year. That may seem robust. But any economic weakness hurts an industry that desperately needs an influx of capital.

UES has made a profit in the past "because the industrial price of electricity is considerably higher, thus the industrial sector is subsidizing the retail sector," says Zach Allen, head of PanEurasian Enterprises. "No one expects this to remain a viable solution. Estimates are that retail prices must increase by two to three times in order for the system to approach a reasonable structure."

Key Questions

Russian executives who demanded the electricity sector be privatized did so under attack. They eventually prevailed and the process got underway beginning in 1994. Two years later, investors such as Italy's Enel, Finland's Fortum and Norway's Nomos-Bank took their bets. As for UES, it will continue to issue stock in the hopes of raising $15 billion. But many investors are now cautious and waiting for better times.

The key question is whether Russia's power industry can hold on. It is dependent on bank debt and right now it is unable to get the financing it needs -- a situation not helped by the fact that major customers are not paying on time. Unlike the economic crisis that the nation experienced in the late 1990s, Russia has saved for a rainy day. But if the downpour persists, then its reserves that would be used as collateral will dry up.

Attracting investors to an industry with highly subsidized rates is paradoxical. If power producers were to recapture their costs and earn fair returns, prices would likely jump as much as 200 percent. But Russia is not about to pull the plug on all state controls. It will, instead, move cautiously and try to open markets so as not to dislocate its people. Perhaps a first step, says Pan Eurasian Enterprises, is to add the technologies that would increase the relatively low efficiency rates of existing power plants.

And while the restructuring process appears as if it will get put off, some analysts are warning the nation not to delay liberalization too long. In time, the demand for power there will resume. That will call for Russia to have a modern and expanded electricity infrastructure -- something that can only be accomplished if investors can earn a profit. The ultimate goal is to better compete internationally.

"We are very concerned that the entire process of reform may be stopping and even reversing," says Kevin Dougherty, a portfolio manager at Moscow-based Pharos Fund, in an Associated Press story. "I think that's a very real risk here. The whole idea of charging market prices for power was always politically contentious."

It's harsh climate, necessitating that the original plan be postponed. No question, adding efficiencies to both the Russian grid and power plants are paramount. But so is maintaining domestic stability. If the global downturn reverses course in a reasonable timeframe, Russia will be alright. It will then be able to open its markets and draw the required capital to advance its economy.