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19/03/2009 | Russia - The Electricity Sector in Jeopardy

Stratfor Staff

Russia’s electricity sector could end up on the list of casualties in the global financial crisis.

 

The sector has long needed fresh investment, and now that the crisis has hit, funds for that investment have dried up. To prevent the sector from collapsing, Russia must either rush the planned liberalization of electricity prices, or wait for the financial crisis to subside to address the electricity sector’s needs.

Since the global financial crisis began, Russia has faced challenges across a broad range of economic sectors. From the banking industry to major energy firms and industry, Russia has seen significant decreases in output and performance. But there is another industry hit hard by the ongoing crisis that is not discussed nearly as much, though it is no less important than the headline-grabbing industries: Russia’s electricity sector. This sector was in dire need of assistance even before the financial crisis hit, and further neglect could eventually force the lights off in Russia — literally.

Russia is enormous, and so is its electricity sector. Russia produced more than 960 billion kilowatt hours (kWh) of electricity in 2008, making it one of the world’s top five producers. This output is enough to satisfy Russia’s entire domestic electricity demand and provide exports to many neighbors, including (but not limited to) the former Soviet states, Turkey, China and Finland. Most electricity generated in Russia — 63 percent — comes from thermal power (through resources such as natural gas, oil and coal), though hydropower provides 21 percent and nuclear power provides 16 percent.

Until 2008, Russia’s electricity sector was monopolized by a company called Unified Energy Systems (UES). UES was responsible for maintaining the complex network of plants and grids that provides electricity to the vast Russian land mass, and for exporting electricity abroad. Because of the size of the electricity network, and the fact that many of Russia’s nuclear and electric plants are 20 or more years past their prime and in need of modernization and repair, it became clear to the Kremlin that the electricity sector was sorely in need of major investment after being virtually ignored for decades. The head of UES, Anatoly Chubais, determined that approximately $850 billion in investment was required by the year 2020 to construct new power facilities, modernize existing ones and update the seemingly endless transmission lines. Chubais’ estimate might seem like an enormous figure, but it is realistic in relation to the electricity sector’s size and degree of decay.

The problem is that electricity prices in Russia are heavily subsidized, which cuts into any profits that could fund such an investment scheme — meaning that no company inside Russia wanted to take on this sector and its huge investment needs — and the Kremlin simply does not have that kind of cash to invest. So Chubais, along with then-President and current Prime Minister Vladimir Putin, drew up a plan in 2003 to attract foreign investment to capitalize the overhaul of the electricity sector. They decided the best way to get foreign companies interested was to comprehensively privatize the electricity sector by breaking it up into chunks to auction off to these companies (while the national and regional electricity grids themselves were to stay under state control). Though this is atypical of standard Russian methodology, considering the large consolidation and nationalization occurring in most sectors, Moscow needed the investment badly. So to bring in foreign companies — which are generally wary of trusting the Kremlin to not nationalize assets — Moscow promised to liberalize electricity prices by 2011 by doing away with subsidies in order to make investment in the electricity sector profitable. This plan was thought to be workable because of the considerable increase in the average Russian’s income at the time.

The plan effectively dissolved UES by June 2008, and large foreign electricity companies like Germany’s E.on, Italy’s Eni and the United Arab Emirates’ Dubai World bought or planned to buy up large pieces of the former Russian monopoly’s generating companies with plans to invest in their modernization. Not all of what was once UES went to foreign investors, however. Even though the Russian government said it would abstain from the auctions, the four most strategically important generating assets (including those that supply electricity to the Moscow and St. Petersburg regions) were bought up by a state-owned company: natural gas behemoth Gazprom.

Gazprom’s involvement made things inherently more complicated for both the foreign investors and the Kremlin. The electricity sector depends greatly on natural gas to power its plants, and the majority of that natural gas is provided by Gazprom. Gazprom provided the domestic electricity sector with heavily subsidized rates for its natural gas, charging $28 per thousand cubic meters (tcm) to the power plants — below the cost of extraction (by comparison, it charges its European customers $400 per tcm). But since the Kremlin had agreed to liberalize electricity prices (which would cause the price to jump toward market rates), Gazprom demanded that natural gas prices be liberalized to make up for this difference and secure a profitable role for itself. If it continued to subsidize natural gas prices to electricity companies, liberalized electricity prices would cause Gazprom to pay more for its electricity (which it uses to extract natural gas), hurting Gazprom and its profits disproportionately.

This created an interlinking chain of puzzle pieces, in which every piece needed to be firmly in place for the plan to work. The modernization of the electricity sector, the vast sums of investment required for this modernization, and the liberalization of both electricity prices for the foreign investors and natural gas prices for Gazprom all needed to line up perfectly if any progress was to be made. If one piece fell out of place, any movement would essentially grind to a halt.

And then the global financial crisis knocked a piece out of place. The crisis hit Russia, along with the European and Gulf investors that were once flush with cash and ready to invest in Russia’s electricity sector. This has forced the foreign companies that own pieces of the electricity sector to make drastic revisions to their investment programs, as they are struggling with their own domestic economic issues and are unable or unwilling to follow through with the capital needed for modernization. Some have frozen their investments, while others like Dubai World already have withdrawn their multi-billion dollar offers.

In addition to the financial difficulties, worries also remain about the demands and intentions of Gazprom, which has hardly been a reliable partner for foreign firms in the past. Gazprom has been known to act according to its own interests at investors’ expense, causing foreign companies to be wary of entanglement with the state-owned giant. Even if that were not an issue, at this point two more years appears to be too long for foreign companies to wait for the liberalization process. That liberalization was the main motivating factor for the foreign companies’ purchases, and timing is critical when capital is scarce and balance sheets are in the red. Add to this the fact that the electricity sector is inherently messy and difficult to break down, and that electricity is generated from various sources (unlike an oil or natural gas pipeline), and the problem is compounded even further.

The bottom line is that no cash — foreign or domestic — is flowing into Russia’s electricity sector. Either liberalization must come sooner, or Moscow will have to wait for the economic recession to subside to tackle the sector’s burgeoning problems. The social implications of liberalized electricity prices during a recession could turn out to be troublesome for Russia as industrial production falls, wages stagnate and unemployment numbers rise. But if the Kremlin cannot establish some sort of understanding between foreign investors and Gazprom sooner rather than later, the electricity sector will continue to decay and the lights could eventually go out. At this point, the Kremlin very well may not know how to work out such a plan.

 

Stratfor (Estados Unidos)

 


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