Russia's energy sector: green grass with hurdles

June 5, 1997 Foreign investment in Russia's energy sector offers a potential wealth of opportunity to foreign investors. The importance of the energy sector to Russia's economy cannot be over-emphasised. The sector currently provides more than 40 % of Russia's federal budget revenues, with additional benefits flowing to the national, regional and local economies from energy companies themselves.
To fuel any future economic growth, energy production in Russia must expand to meet expected increases in both domestic and overseas demand. Increased energy production, however, will not come without increased foreign and domestic investment and improvements in technology.
In 1995, Russia managed to attract only 1 % of $ 240 billion of world foreign investment. In coming years, if Russia cannot attract needed investment, the energy sector will emerge not as the key to Russia's growth, but as a drag on Russia's economy.
Within the energy sector, Russia's oil industry has attracted the most attention from foreign investors. Since 1991, Russia has taken a number of steps to privatise its oil sector and attract significant amounts of investment. The big projects, however, are still on hold. And current investment in Russia's oil industry is small compared to the massive amounts expected to flow to Russia if the government takes necessary steps in the areas of production sharing legislation, oil sector taxes and pipeline transportation capacity. If these steps are taken, Russia can expect investments of $ 50 billion to $ 70 billion over the life of proposed production sharing projects.
While many oil companies continue to wait for the Russian government to take action in the oil sector, international power companies are beginning to look at opportunities for foreign investment in Russia's electric power industry.

Russia's power industry is in need
Like the oil industry, Russia's power industry is in need of investment. According to the American Chamber of Commerce in Russia, 50,000 MW to 70,000 MWof existing capacity in Russia is operating beyond its useful operating life and in need of replacement. In addition, due to ageing equipment, available capacity is estimated to be 10 % to 20 % less than installed capacity of about 213,000 MW.
The true need for investment in this sector has been somewhat hidden, however, because the decline in industrial production during Russia's economic transition has lessened the country's demand for power. Although the Russian Federation as a whole currently has excess power generation capacity, several regions are under-served. And, like the oil sector, massive investments are needed to support any future economic growth.
Projected demand and scheduled shut downs to retire ageing equipment could lead to serious power shortages, constraining Russian GDP growth until capital improvements are made. Upgrading or replacement of inefficient and environmentally damaging equipment requires large capital investments. The amount of financing required could total between $ 32 billion and $ 81 billion, depending primarily on the demand for power. The organisations which dominate the Russian power sector include the country's national power company, Unified Energy Systems (UES), which controls more than 50 of the largest thermal and hydroelectric plants and the country's unified power grid. Next are the regional utilities, 72 in all, which control the remaining power plants in their regions. Third is Rosenergoatom, the nuclear power consortium, which controls the country's nine civilian nuclear power plants. The majority of the regional utilities and UES have been privatised; however, the Russian government still holds a majority of their stock. The Russian government currently considers UES a natural monopoly.
Of Russia's generation capacity, 21 % is hydroelectric, 10 % is nuclear and the remaining 69 % is fossil-fired thermal. Natural gas provides 65 % of the fuel required by fossil thermal plants, and this %age is expected to grow.

Money to invest, bills to pay
Foreign investment has not flowed into Russia's power sector for several obvious reasons, including non-market pricing, a non-payments crisis and lack of financing methods. In short, Russia has not yet created an investor- friendly commercial system.
Prices for electric power are regulated nationally by the Federal Energy Commission (FEC) and regionally by the Regional Energy Commissions. The FEC regulates prices of electricity generated by UES plants, power transmission charges and inter-regional power trade. The Regional Energy Commissions set local power prices, including household rates. Average household rates in Russia range from 2.5 cents to 3.7 cents for the first 160 kWh and rise to 6 cents per kWh for additional power use--by way of comparison in the US rates average about 8 cents per kWh. Russia's low household rates discourage the development of energy efficiency and conservation. In addition, the rates are often set for political rather than economic reasons, and some observers have remarked that it is not unusual to see changes in rates before national and regional elections.
Another serious crisis facing Russia's power sector is the issue of non- payment of electric bills by households and industries. Regional utilities are especially vulnerable to the danger of non-payments, with payment arrears often ranging from 40 % to 70 % of sales, depending on the utility. This prevents the utilities from being able to finance equipment upgrades and has led to an inability of power companies to pay for fuel to operate their enterprises. Subsequently, this has led to power outages around the country.
A third major barrier to investment in Russia's power sector is a lack of available financing. The Russian power sector's short-term equipment financing is limited due to the financial instability of most Russian power enterprises stemming from the non-payment crisis. The IMF is putting greater pressure on the Russian government to improve collection, but in the short term the problem remains.
Long-term equity and debt financing is hindered due to the lack of an acceptable regulatory framework necessary to support such investment and financing. According to the American Chamber of Commerce in Russia, the problems surrounding long-term financing include the inability of financiers to enforce long-term contracts, lack of acceptable guarantees from the government to investors, excessive duties and import taxes and operating requirements that would be unacceptable for power project financing, such as the inability to terminate service to non-paying customers.

Changes at hand?
Fortunately, there is some indication that the Russian government may be taking steps to make its power sector more attractive to foreign investors. The government has been gradually increasing electricity rates for households and states that will bring them to the level of production costs by the year 2000. In 1996, the government passed a law on energy conservation, which may help the country achieve some considerable energy savings.
In one of the most important moves, in January 1997 Yevgeny Yasin, Minister of Economy at the time, announced a proposal to restructure the natural monopoly in power. Addressing issues such as pricing, regulatory development and non-payments, the proposal may be a first step toward the demonopolisation of the power sector and the creation of conditions that improve transparency, competition, and tariff and regulatory mechanisms.

Great potential for foreign investors
Even with the significant barriers to investment, Russia's large market holds potential for foreign investors in the power industry. While investment in, and development of, private power projects will be of longer-term interest, in the near term the greatest opportunities are in supply of power generation equipment.
According to the Russian Ministry of Fuel and Energy estimates, the most significant needs are for increased efficiency or capacity, emission reduction equipment for existing combined-cycle steam powered units such as turbines and associated controls and computer-based energy management systems for internal power plant operations and system level control. Opportunities are also cited in environmental control equipment for coal and gas-fired power plants and improved controls and metering systems for district heating plants.

Due to the non-payments crisis, Russian power enterprises are cash-strapped. The leading power equipment suppliers can expect intense competition from lower-priced, Russian-produced equipment. To compete, some foreign companies attempt to supply equipment through local manufacturing with Russian joint- venture partners.
In the past, the Russians have been reluctant to encourage or even allow foreign investment in such a strategic sector as electric power. Building a record of successful foreign investment projects will serve to overcome this reluctance. One way companies can increase their chances for success is to identify Russian power plants, which due to favourable geographic or political location or forward-looking management, are generating sufficient funds for investment in equipment upgrades. Examples include utilities that are geographically able to sell power to Western Europe or that have relationships with industrial organisations that sell their product for hard currency.
Overall, the Russian power sector provides a mix of opportunities and challenges for companies considering expanding their business in this market. With its wealth of natural resources and vast power sector potential, Russia has much to offer forward-looking power investors. With the right preparation, investing in Russia's power sector can be a win-win situation for Russia and interested companies.