**KEY ISSUES INRUSSIAN POWER SECTOR INVESTMENTS**

 

by MayraRodriguez Valladares

 

Currently, most Russian power sector analystsand bankers remain neutral to bearish on the power sector. Cash collectionrates, although improved over the last quarter, remain relatively low byWestern standards. Also, with upcoming parliamentary and presidentialelections, officials are not focusing on necessary reforms in the power sector.Despite the weakness of the sector, now is a good time for U.S. investors toconduct significant due diligence on the Russian electricity sector, which isthe country=s second largest in terms of marketcapitalization and daily trading volumes. Investors need to approach theRussian Ministry of Fuel and Energy, United Energy Systems (UES), and theregional utility companies (energos) if they are interested in electricitysector investments. Also since regional governors exert significant influenceon companies, particularly utility companies, in their regions, visits toregional governors and their staff are an important part of the due diligenceprocess.

 

One key for any investor contemplatinginvestments in the Russian power sector is to understand the sector=s reform process as it is currently beingundertaken. 

 

**The Status of Reforms**

Despite talk about reform, the power sectorhas not been restructured or privatized. Generating, distributing, andtransmission assets have not been separated. The United Power Grid of Russia,which is the world=slargest power pool with centralized management, is one of the mostcontroversial aspects of the Russian power sector, since it is controlled byUES. UES has stakes in most of the country=s regional utility companies, and it establishes the prices at whichthese utility companies can buy and sell electricity from the grid, posing asignificant conflict of interest. Also, industrial customers are not able tobuy directly from the grid as can customers in emerging markets such asHungary. This restriction hinders industrial customers from having a choice ofelectricity providers and means that there is no incentive for utility companiesto compete. In addition, industry continues to subsidize consumers for theirelectricity use. 

 

Electricity tariffs for industrial orresidential users only cover about 50 percent of costs. Given thatparliamentary and presidential elections will take place this year and next,respectively, tariff realignment is unlikely before 2001. It is not surprisingthat Russian power companies have a significant nonpayments problem, recoveringanywhere from 70-80 percent of their revenues. Only between 15 and 30 percentof these revenues are in actual cash. The rest is barter, which takes the formof actual goods exchange or tax-offsets where electricity companies do not paytaxes to the government because government entities such as hospitals andschools often do not pay their electricity bills. 

 

**Challenges to Reform**

Five major challenges exist in reforming theRussian power sector. First, the obvious, the scope and size of the sector areenormous not only because of the size of country and the extent of thenetworks, but also because of the great differences in fuel type capacitythroughout the country. Domestic and international government officials musthave great patience in instituting reforms and must be aware of the vastdifferences between Russia=s 89 regions. 

 

Second, because the ownership of the sectoris so diversified, reform becomes even more difficult. When the RussianGovernment began electricity reforms, the sector was already partiallyrestructured and privatized. Most developing countries usually begin reforms byalready having one fully integrated state-owned electricity monopoly and thenmove from there to separate distribution and generation and to privatize thewhole sector. 

 

Third, the nonpayment problem needs to betackled at the source. That is, insolvent government entities and companiesshould be made bankrupt and their power supplies cut. This is a challenge towhich the government has not risen because of the potential for politicalbacklash. Moreover, the country would need significant funds to restructure thesector and to provide a social safety net during the reform process. 

 

Fourth, from the government to the worker onthe ground at a power plant, a commercial mentality needs to be encouraged. TheRussian Government and even UES see UES= role in the sector as insuring stable power supply throughout Russiaand investing to meet future needs, but not in maximizing the investment valueof UES or of the energos. Decisions are often made without considering how thevalue of the sector can be increased. In essence, profit margins practically donot exist. 

 

Fifth, the power sector is extremelypoliticized at both the national and regional level. Moreover, Gazprom has beenincreasing its influence by acquiring electricity assets in exchange forutilities= bad debts to the company. Because of theintertwined nature of the power sector with every facet of Russian life,whatever party or business entity that controls UES controls Russia. As such,until after the presidential elections, officials will spend their time tryingto control UES and the regional utility companies, rather than reforming andimproving this vital sector.

 

*Mayra Rodriguez Valladares is an emergingmarket energy specialist and author of*Reforming the Russian Electricity Market*recently published byFinancial Times Energy. FT Energy, tel: +44 (207) 463-8184, fax: +44 (207)896-2121, or visit*www.energy.ft.com*and reference 29224C.*