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22.10.07
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Lighting Up Europe
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By Graham Stack
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EU Power Companies Line Up to Rewire Russia’s Electricity
The Russian electricity sector has had a tough time over the past few decades. During the Soviet era, power generation played catch up with the power-hungry heavy industry favored by Soviet planners. The 1990s might have brought a respite, as demand for electricity slumped during economic collapse, but instead, nose-diving customer solvency turned the electricity sector into a Kafkaesque charade of non-payments and barter.
The powerful economic revival gripping Russia since 2000 replaced this set of problems with yet another: Decades of underinvestment in conjunction with price regulation meant that soaring demand for electricity looked set to outstrip capacity. In 2006 alone, electricity consumption in Russia increased by 4.2 percent, more than double the official government forecast, reaching 97 percent of capacity. Electricity monopolist UES anticipates consumption tripling by 2020.
Analysts estimate that between $30-$60 billion of capital investment in the power sector will be required to avert acute electricity shortages within the next five years. According to some estimates, the electricity sector’s total investment requirement from 2007 to 2030 will be at about $350 billion, 1.9 percent of the country’s GDP over the period.
Without this investment, the Soviet-era electricity sector will strangle industrial growth as surely as Moscow’s Soviet-era road network has snarled up the city’s traffic.
Russia’s witch doctor
Cometh the hour, cometh the man … again. Anatoly Chubais, the godfather of reform in Yeltsin’s Russia who has served in the Putin era as CEO of UES, took on himself the restructuring of the giant utility with the aim of attracting investment - by demonopolizing and selling off power generation.
Chubais, like a witch doctor, is someone Russia turns to when all else fails. His vast army of enemies predicted that he would be the death of UES – and they were right. Ten years after Chubais became CEO, UES is set to disappear in July 2008, leaving behind six privatized wholesale generating companies (WGCs), fourteen privatized territorial power and heat generating companies (TGCs), a state-owned hydroelectric generating company and state-owned grid.
In fact, Chubais’ grand plan avoids the word “privatization” altogether, talking euphemistically about “reducing the state’s share by the extent required by investment needs,” and attracting “strategic investors.” But since the utility’s investment needs are infinite, the state’s share in thermal generation assets should be eliminated altogether.
Kings from the West
And the plan seems to be working – and not just for Russian conglomerates diversifying into the sector. What caused the Russian business world to buzz in 2007 was the arrival of major European energy concerns on the Russian power generation scene, bringing with them not only sizeable war chests for further acquisitions and investment, but extensive know-how in energy markets and state-of-the-art technology.
Refuting the skeptics, in early June 2007, Italian energy giant Enel purchased 25.03 percent of WGC-5 for $1.5 billion, paying a 15 percent premium over the market price. Enel will now spend a further $3.88 billion buying the company’s remaining shares, giving complete control of 5.8 percent of Russia's thermal power generation.
Then in September, Enel’s sparring partner on the European market, Germany’s E.ON, paid $3.9 million for 40 percent of WGC-4.
Following the Russian authorities’ unfriendly behavior to foreign investors in the Sakhalin projects, Russia’s readiness to part with large chunks of its generating assets raised eyebrows – as did foreigners’ readiness to buy them.
If Russia’s willingness was dictated by a looming power shortage, what moved foreign energy giants to get major exposure to such a dilapidated sector of the economy?
“There is simply no other country in the world offering this scale of market liberalization,” says Alexander Kornilov of Alfa Group. “It’s not just E.ON and Enel that are interested. Fortum, Gaz de France, RWE, IES from the States and Korea are all up for it.” Indeed, UES is the world’s fourth largest electricity grid, after the United States, China and Japan, with around 993 billion kilowatt hours (kwH), compared with India’s 727 billion kwH, and 2.6 million km (1.6 million miles) of electric lines. The size of each of the WGCs up for sale is, for instance, more than half of Finnish concern Fortum's entire current production.
“The second reason is that the assets are very cheap in European terms” says Kornilov. Although large sums were paid for Russian power assets, averaging a 15-20 percent premium over market price, the prices paid were still only roughly half of the going rate in Western Europe: E.ON paid $750 per kWh for OGK-4, Enel $670 per kWh for OGK-5. Moreover, Enel and E.ON are currently flush with cash, each with a war chest for funding acquisitions totaling 15-20 billion euro ($12-28 billion), with credit lines more than twice that size. E.ON had, after all, been prepared to pay 41 billion euro ($58.1 billion) to acquire Spain’s Endesa.
Gambling on price liberalization
Why are UES assets so cheap? There is a simple reason, according to Derek Weaving of Renaissance Capital: “None of the companies currently turn a profit. The whole investment case is based purely on the hope that price liberalization will go ahead as planned. The investment community generally calls buying companies at half price that don’t make a profit ‘speculation’,” he adds.
In fact, Russian utilities have been open to investors ever since Chubais took over the helm of UES in 1998. But foreign investors showed little interest, due to low, fixed prices. That all changed when, as part of the UES reform, the government agreed to free prices for the non-household sector by 2011, with market competition to determine prices as of that date.
This is where politics comes in.
Investors seem convinced by Chubais’ argument that the energy sector’s investment needs are so vast that there is simply no alternative to price liberalization.
If a future government were to bail on this promise, the investment case would disappear. Nobody knows what industry’s reaction to such an increase will be. If things turned ugly, nothing would be easier for a future government than to turn round and say ‘it was all Chubais’ fault’ again.
Also, nobody even knows if the market trading will work as planned.
It is not just the price at which companies can sell electricity that is critical. There is an equally political question concerning the price of the gas from which 70 percent of Russian power is generated.
The gas price to non-household users is set to rise to reach European profit levels by 2013. A nightmare scenario would be a rising gas price lobbied by monopoly Gazprom, but a fettered electricity price to protect industry.
A further risk for strategic investors results from the weighty role of Gazprom in power generation itself. Gazprom is moving into power generation in a big way, and looks set to own around 40 percent of generating capacity. This brings up all sorts of risks, ranging from market domination, to Gazprom manipulating gas supplies, to the risk of anti-monopoly authorities reinstating price regulation.
On the other hand, strategic investors might actually be banking on Gazprom’s involvement as a guarantee of price liberalization because Gazprom has a massive interest in weaning the electricity sector away from cheap gas towards coal, oil, hydro and nuclear power. In 2006, gas consumed by UES was equivalent to 73 percent of Gazprom’s entire exports to Europe. Gazprom’s declared aim of investing in the electricity sector is precisely to ‘release’ gas for export. In other words - to generate gas from electricity.
The European dimension
Another powerful motive for Enel and E.ON to move into Russia comes from their tight position on the European market.
The initial phase of European deregulation saw the emergence of huge private energy concerns such as E.ON, Enel, and Endesa, which are driven by shareholder value – and suffering from low domestic returns.
Derek Weaving explains: “European utilities struggle over the cycle to make returns, so it’s obvious for them to invest somewhere, where with 5 percent of annual demand growth, they could make 2 or 3 times the returns they make on the European market.”
The low returns on their domestic markets are exacerbated by the very strict anti-monopoly regulation of former national monopolies such as Enel. “Enel, for example, was forced to sell off generating capacity and is prohibited from expanding on its domestic market, leaving its only option to expand abroad,” Rencap’s Kornilov explains. But at the same time, some European governments – Spain and France most notably - have a track record of defending their ‘national champions’ against foreign takeover bids: Enel was stymied in its bid for France’s Suez, and E.ON rejected by Spain’s Endesa.
With organic growth and European acquisitions equally difficult, Enel and E.ON, in their frantic search for acquisitions, to swallow or be swallowed, have now turned their attention to Russia.
While such spending, according to Derek Weaver, is speculative, there is also a hidden strategic element – connected to gas, not electricity. Both companies’ domestic power generation is heavily dependent on gas, while supply security is looking increasingly shaky. “Gas is ultimately their main interest in Russia,” says Weaver. Both companies are already engaged in gas extraction in Russia – in itself no mean feat. Since reforming the electricity sector will free up gas for export, they are as much partners as competitors of Gazprom in the power sector. They might count on later appreciation of this from the Russian giant, of which E.ON already owns 6 percent. Such appreciation could mean priority status in terms of securing gas supplies, and even favored status as partners in exploiting Russian gas fields.
According to the PricewaterhouseCoopers annual survey of energy company CEOs in 2006, in the aftermath of the Russian-Ukrainian gas dispute, half of Europe's utilities were expecting gas shortages or supply interruptions in the medium term. In the same year, Enel CEO Flavio Conti told an Italian parliamentary hearing: "a repeat of the Russian gas crisis we saw in the 2006 winter – state of affairs which unfortunately could well reoccur – could bring the system to a point of collapse."
Taking this into account, Anatoly Chubais might well have Gazprom’s monopolistic heavy handedness, just as much as his own reformist sleight of hand, to thank for Europe’s sudden interest in Russian electricity.
Graham Stack is a staff writer for businessneweurope.eu. |
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