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Electric Shock in Russia

The famously monolithic Unified Energy System, Russia's power supply, is being divided and offered for private purchase, even to foreigners

Communism, Lenin once remarked, equals Soviet power plus the electrification of the whole country. Such was the thinking that gave rise to Unified Energy System, Russia's vast power concern. With 580,000 workers, 440 power stations, and 2 million miles of power lines, UES is a sprawling empire that produces more than 70% of Russia's electricity. With annual consumption of 980 trillion kilowatt hours, Russia gobbles up more of the stuff than any country in the world, except for the U.S. and China.

But if Lenin were alive today, he might be in for a shock. That's because this ultimate symbol of communism is now being broken up and sold off, chunk-by-massive-chunk, to private investors. The ambitious program is the largest privatization project in Russia since the early 1990s, and also one of the most radical electricity reforms anywhere in the world. This year alone, UES is hoping to raise no less than $15 billion from 15 major asset sales. "It's a fantastic event. This is the biggest movement of assets anywhere in the world," says David Herne, a UES board member and managing director of Halcyon Advisors, a consultancy advising on the reform.

In many ways, Russia's bold electricity reform is a surprise. In strategic sectors from oil to aerospace, the Russian state has been expanding its ownership and influence, and President Vladimir Putin has increasingly moved away from the pro-market reforms with which he flirted during the early years of his presidency.

Paying for Crumbling Infrastructure

Yet the one big exception is electricity, where the Kremlin seems to have been persuaded by the radical reform arguments put forward by Anatoly Chubais, UES's chief executive officer since 1998 and the chief architect of the plan. No stranger to controversy, Chubais was previously a top economic adviser to Putin's predecessor, Boris Yeltsin, spearheading the privatization program that saw most of Russian industry sold off in the early 1990s.

The major argument put forward by the reform's advocates is the need to attract massive amounts of investment—around $100 billion between now and 2010—to renovate Russia's crumbling electricity infrastructure. Most of Russia's generating equipment and power lines were built decades ago. Adding to the strain is rapidly rising electricity demand, now growing by around 5% each year on the back of strong economic growth.

The gap between capacity and demand is closing fast, leading to growing supply problems that included a major power blackout that hit Moscow in 2005, bringing much of the city to a standstill. "Putin is intelligent enough to realize you need this reform," says Herne.

Big Investor Appetite

At the heart of the plan is the sell-off of Russia's non-nuclear power stations, which have all been parceled out into 21 new power-generation companies, all but one of which (responsible for hydroelectric power) have been slated for privatization. The new companies include 14 that have been organized territorially, with power plants concentrated in particular regions of the country, and seven with assets that are spread out in different parts of Russia. Over the coming months, large stakes in the new generator companies will be sold off in open tenders.

The first such sale, on Mar. 11, was an encouraging sign of investor appetite. OGK-3, which operates power plants in several parts of Russia, attracted bids from several Russian and international companies including Gazprom, Gaz de France, Italy's Enel, Finland's Fortum, and three other local bidders. The winner, Russian nickel mining giant Norilsk Nickel, paid $3.1 billion for the 38% stake, paying a 13% premium on the current share price.

For Norilsk, the purchase of power assets is a useful complement to its existing mining business, allowing it to hedge against higher energy prices. For similar reasons, other large local corporations, such as metals concern Russian Aluminum, are among those now eagerly eyeing electricity assets. Meanwhile, Gazprom, Russia's state-dominated gas concern, is also emerging as a significant player. In a separate deal with UES, it has recently acquired a majority stake in Mosenergo, the electricity generator that serves the Moscow region.

High-Efficiency Hopes

The expectation is that by bringing competition and new management into the sector, the reform will not just attract much-needed investment, but also promote economic efficiency and transparency. At the moment Russia's power sector is not exactly known for either. It costs around twice as much to build a power plant in Russia as it does elsewhere in the world.

"It's a very good reform. It's one of the least efficient sectors of the Russian economy, which will probably become one of the most efficient," says Alexander Branis, a UES board member and portfolio manager for Prosperity Capital, a large equity investment fund in Russia. He expects that as a result of privatization, the value of Russian electricity shares will rise. At the moment they are only worth half of what they would be if the sector were run as efficiently as it is in other countries.

Of course, Russia being Russia, not everything about the reform is positive and straightforward. "The only question is whether Gazprom will get a lot of these assets, because they will not be run in the best possible way in Gazprom's hands," says Branis. Russia's large gas concern is 51% owned by the state, and not known for low costs and efficient management. If it ends up dominating the power sector as well as gas, the result of the reform will simply be to transfer assets from one large state monopoly to another.

Low, Low Prices

A related question is how open, in practice, the forthcoming tenders will be for foreign investors. "Clearly for Russia, a foreign buyer would be extremely positive. It would bring in new standards, technology, and corporate governance," says Herne. Although several foreign companies are showing interest, it remains to be seen just how much money they will be willing to put up—and whether it will be enough to outbid the likes of Gazprom.

One possible deterrent is uncertainty about the future of Russia's regulated electricity tariffs. At about three cents per kilowatt hour for wholesale buyers, and seven cents for retail customers, these prices only barely cover costs. On the positive side, Russia has made significant progress in raising prices closer to market rates over recent years: In 2002 Russian retail consumers paid just 1.6 cents per kilowatt hour.

Chubais has said he is very keen to attract foreign buyers, a goal that doesn't appear to have met serious objections. "No one in the government is particularly concerned about preventing foreign investors, if they are prepared to pay acceptable prices," says Branis. So, before long, even Western corporations may be pumping electricity to Russian factories and homes. What would Lenin have said about that?

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