Russian electricity market: Sell-off in a cold climate

Russia is opening up its electricity market to foreign investors. But when energy prices and presidential elections are so closely linked, will the state really let power slip from its grasp?

The two Vickers generating turbines were installed in the CHP-5 power station two miles south-east of St Petersburg in 1929 and still supply power to the city today. They are testament to the durability of British engineering - but also to the decrepit state of Russia's electricity network.

As it seeks Western-style market reform, the owner of the plant, the state-controlled generating group Unified Energy Systems (UES), wants to raise $80bn (£42bn) to drag itself into the 21st century.

This time, instead of buying Vickers turbines, UES is seeking foreign capital raised through a series of initial public offerings (IPOs) in London.

Run by Anatoly Chubais (who helped orchestrate Russia's controversial privatisations in the Nineties), UES is looking to raise around $10bn by spinning off its generating subsidiaries and selling new shares in them. Investors in London are salivating at the prospect of snapping up large chunks of Russia's power infrastructure. However, the political risk of putting money into Russian assets remains substantial.

The first of UES's subsidiaries to float in London, OGK-5, said last week it would raise £459m from this month's listing. UES is planning to offer shares in 15 more of its power-generating subsidiaries over the next year, and European power giants such as Enel of Italy are lining up to take stakes in them. The opportunities up for grabs in one of the world's largest power markets shine like neon lights.

But foreign participation in Russia's energy sector is being curtailed. In the oil and gas industry, Shell faces the prospect of renegotiating the terms of its giant Sakhalin 2 project, and could be forced to hand over a stake in the operation to Gazprom, the state-controlled Russian gas giant.

Doubts are mounting over the extent of Moscow's commitment to opening another politically sensitive industry - electricity - to foreign investment. And overseas investors are worried that President Vladimir Putin will snatch assets back into government hands once Russia has benefited from an injection of foreign cash.

Anyone who has sat through the horrendous traffic jams in Moscow and St Petersburg will know that the country's Soviet-era infrastructure is struggling to cope with its post-Soviet economic growth. And the electricity sector is no different, with spare capacity about half that of the UK. In June, the Russian Industry Minister, Viktor Khristenko, said that a lack of power plants was restricting economic growth and increasing the chance of blackouts.

The Kremlin agrees with UES that new plants are needed urgently, and has approved the company's plans to build around 24 gigawatts of new capacity (some one-third of the UK's total existing capacity) by the end of the decade. This will account for some $34bn of the total $2.15 trillion rubles slated for investment in the electricity sector.

But the investment risks remain high, with electricity prices still heavily regulated. Analysts from Renaissance Capital estimate that wholesale prices are a third below the level at which it becomes economic to build new power plants, and Mr Putin will not allow UES to increase prices enough to pay for the new investment. They will rise gradually but no one knows by how much - or when. With presidential elections due in 2008, this is a sensitive area. For instance, after a power cut in Moscow last year, Mosenergo, the largest UES subsidiary, which provides power for the city and surrounding region, suggested an increase in electricity prices to pay for upgrades. Mr Putin branded the calls "blackmail".

In a presentation on the reforms, given to analysts and banks in May, Mr Chubais described the "essence of the change" as "large-scale investments not after but during the reform process". In other words, investors - whether foreign power companies or institutional investors buying IPO shares - are being asked to stump up the cash if not blind, then certainly only partially sighted.

The uncertainty has not scared everyone off. Giorgio Cimini is general director of Enel ESN Energo, a joint venture between the Italian power company and a Russian investment group, which operates the North-West Termal power plant, a UES-owned power station just outside St Petersburg. Mr Cimini, who hails from the tiny village of Opi in Italy's Abruzzo region, says he is the first senior foreigner to work for UES. "Enel wanted to experience how the Russian electricity system works," he explains in lilting English.

Despite having run the joint venture for the past two years, he still gets exasperated by Russian bureaucracy. "Every day, every hour, I have to sign something. I have given away a lot of signatures," he jokes.

A more serious constraint for UES and its investors is Gaz- prom, the gas monopoly seen by many as an arm of the Kremlin. Around two-thirds of the country's plants are gas powered and so depend on Gazprom for their supplies. Edward Lisitski, chief of production, planning and technical development at TGK-1, the St Petersburg-based subsidiary of UES, explains that the gas giant is required by law to supply the country's power stations at below market rates. TGK-1 pays half the rate for gas that Gazprom earns from exporting to Ukraine and on to Western Europe. Clearly, there is no economic incentive for Gazprom to supply more to UES. This makes UES's attempts to build more plants almost impossible without the support of the government.

To underline how investors feel they are being left in the dark, consider Enel ESN Energo's plans to build a new unit at its St Petersburg plant. As Mr Cimini explains: "We have asked UES and Gazprom [about construction of the second unit]. We need a new contract to supply gas. You need a political direction."

Whether Gazprom likes it or not, the company knows that more plants will be built, so it is seeking to influence the UES reforms to its advantage. This presents another set of problems for foreign strategic investors such as Enel. Most of UES's existing plants are old and inefficient, and new plants planned by TGK-1 will need less than two-thirds of the gas that its old plants required to generate the same amountof electricity. If Gazprom needs to provide less gas to UES, it can export more at market rates.

Al Breach, the chief strategist of investment bank UBS Bruns- wick, says: "Gazprom could take stakes in some of the operating companies being spun off. It has no experience in electricity but it wants to encourage investment to reduce power stations' consumption of its gas. This would allow Gazprom to export more gas abroad at higher prices."

Enel is not the only foreign utility interested in the UES sell-offs. The German companies E.ON and RWE could also seek stakes in UES subsidiaries, as could EdF of France and Electrabel of Belgium, and may get seats on the board. One banker involved says: "These foreign investors wouldn't get majority control. But they would get access to information."

Fourteen per cent of OGK-5 will be floated and the company said last week that, of these shares, strategic investors would be able to buy only a third. As with the controversial flotation of the Russian oil company Rosneft in the summer, interest from foreign companies appears greater than from institutions, which are interested only in the financial return.

Valeriy Rodin, general director of TGK-1, is looking to raise $2bn by selling shares next year and does not specify whether this will be from institutional investors in an open auction, or from foreign power firms. "Both these outcomes will be possible," he says. "Both are welcome."

When it was founded in 1896, Mr Rodin's company was called the Society for Electrical Power and Lighting. It provided heating oil for the lamps in the Tsar's Winter Palace. The tsars are long gone but foreign investors in UES - strategic and institutional - should be warned: the ties between the Russian state and its energy industry are as strong as ever, despite attempts at reform.

From Russia with no love: Europe needs its gas but Gazprom might not need us

As Western firms eye up Russia's power stations, it is ironic that they have never before been so dependent on Russian gas.

Half of all gas used in Europe is imported, and out of that, Russia supplies around 50 per cent. Gas imports will become more important as production in mature fields within Europe, such as the North Sea, declines.

A report drawn up for European ministers last month predicted that Europe would rely on imports for 80 per cent of its gas and 90 per cent of its oil by 2025. The UK, at the north-west edge of Europe, is last in line for Russian gas and so more vulnerable if the country's supplies are disrupted.

The UK is also more exposed because of the uncompetitive nature of Europe's energy markets, where many gas supplies are tied up in murky, long-term contracts. In contrast, the UK relies more on short-term deals, which would be the first to be interrupted in times of shortage.

UK wholesale gas prices surged last winter to record levels - higher than in the rest of Europe - so supplies should have flowed here, earning big profits for the providers. If a fully competitive market existed in Europe, this is what would have happened. Yet the Interconnector - the pipeline linking the UK with the Continent - only imported gas at half its capacity.

Despite the growth in liquefied natural gas (LNG), which allows gas to be shipped by tanker, pipelines still account for most of the supply. So if the taps are turned off at the source - as Russia did in January in a price dispute with Ukraine - the effects are felt immediately.

Gazprom owns Russia's pipe- line network and produces some two-thirds of the country's gas. Majority owned by the government, it is seen by many as an arm of the Kremlin, both domestically and in foreign policy. Gazprom demonstrated its clout last week when it almost doubled the price of the gas it supplies to Georgia. Russia is struggling to maintain political influence over its smaller neighbour and many energy analysts believe the price hike was connected to a diplomatic spat.

The EU has been trying to persuade Russia to guarantee access to Gazprom's network for other European companies. President Vladimir Putin has yet to agree.

But Germany seems one step ahead of the pack. Energy giant E.ON already owns a large stake in Gazprom, while the former German chancellor, Gerhard Schröder, has been appointed to the board of a Gazprom-led consortium building a $5bn (£2.6bn) pipeline from Russia under the Barents Sea to Germany.

Russia has little choice but to supply gas to its European neighbours as they are its natural customers - for now. But the west Siberian gas fields which supply Europe are maturing. Much of Russia's enormous untapped gas reserves - the largest in the world - lie in the centre, north and east of the country.

So Russia is increasingly looking to the energy-hungry Chinese and Indians as future customers. Earlier this year, it agreed to build two huge pipelines to supply China with 80 billion cubic metres of Siberian gas per year. And once the new pipelines to the east are finished, Russia will count most of the world's developed countries as potential customers.

That is good news for Mr Putin, but potentially bad news for a UK and Europe growing more and more reliant on Russian gas to fuel its power stations.