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Russia: YeES CEO Chubays Comments on Power Industry Reform -- GRAPHICS

CEP20021217000272 Moscow Ekspert (Internet Version-WWW) in Russian 16 Dec 02

[Interview with Anatoliy Chubays, chairman of the board of RAO YeES Rossii, conducted by correspondent Nikita Kirichenko: "Goal of Reform is Appearance of Strategic Investors" (Internet Version-WWW) --correcting to add graphics to text]

[FBIS Translated Text]
     On 18 December, the State Duma is to review the packet of laws on reform of the electrical power industry in the second reading.    On the threshold of this event, Chairman of the Board of RAO [Russian joint-stock company} YeES Rossii Anatoliy Chubays has agreed to answer questions for Ekspert.

     [Correspondent]    On what do you base your assurance of the fact that, if reform of the electrical power industry does not lead to a reduction in tariffs, then it will at least have a decisive effect on the slowing of their growth?

     [Chubays]    The real situation in the country is developing in such a way that, in the next 2.5 years, growth of tariffs is absolutely inevitable, regardless of whether the reform will take place or not.    Internal contradictions have built up in the sector, which are developing according to their own laws and will be manifested prior to the reform.    I will cite one example, which is called the "problem of access by major consumers to FOREM [Federal Wholesale Market for Electricity and Generating Capacity].

     Here is the essence of the matter.    One of the existing internal contradictions in the power industry is "cross subsidization."    There are several types of cross subsidization--for heat, electrical energy, inter-regional, and so forth.    But perhaps the most acute of these is cross subsidization of the population and industry.    It is a fact that a kilowatt-hour consumed by a large industrial consumer, simply for physical-economic reasons, costs less than a kilowatt-hour consumed by the public.    This is rather simple to explain: A large consumer uses electrical grids of high tension (500, 330, 220, 110 kV), over which electrical energy goes to the region and requires practically no transformation in tension.

     But household electrical appliances operate at 220V.    And in order to remove the "kilo," it is necessary for [the power] to pass through several transformer substations, each of which costs considerable money.    As a result, objectively the price of electrical power must be lower for industry and higher for the population.    This is not because Chubays is a bad guy, and not because reform is anti-popular.    It is simply that this is the objective side of the matter.

     But in reality, the picture today is just the opposite: Tariffs for the population are lower than for industry.    Now let us put ourselves in the position of any major industrial consumer.    He buys electrical energy from the local AO-energo [energy joint-stock company] at an average price of 80 kopeks (let us overlook the large disparity between regions), while the population buys it at 40 kopeks.    The very difference in price is a reflection of that same cross subsidization.    The industrial consumer, in buying electrical power from the AO-energo, pays more specifically because the population pays less.    And the AO-energo itself buys the electrical power on the wholesale market at a price which is 1.5-2 times less.    The average price on the wholesale market is around 35 kopeks.    What will the major consumer do?    He will run to FOREM, where as a result of the lower tariff he can get $10-$15 million a year in savings on expenditures for electrical energy.    Imagine what a volume of resources an enterprise could allocate for resolution of all problems (legal and others) associated with this access to FOREM.    And it will allocate this money.    It will solve these problems.

     The consequences for the electrical power industry are enormous: For the AO-energo, the withdrawal of one or two major consumers to FOREM means a loss of from 50-80 percent in revenues to the income articles of the budget, specifically because the one leaving is the one who bore the burden of cross subsidization.    In the existing system, the only method of somehow combating the decline in revenues is by shifting the additional tariff load onto the population and onto small-scale consumers.    This would entail explosive, catastrophic, consequences: Growth of tariffs for the population in specific regions and in a specific situation by 2-3 times, generally without any preparation and without any compensation whatsoever.    This is an absolutely unacceptable scenario of development, but its threat is real.    While even last year this existed at a level of theoretical considerations, today major companies are already undertaking specific actions to access FOREM.    We are trying to hold back this avalanche, but our efforts will not last long.    Immediate solutions are needed.

     Trend in prices for electricity in Russia (considering denominatio 1998)

     I have cited only one of the examples of how domestic disproportions in the power industry are beginning to crop up today, and will continue to crop up in the future.    I can cite other examples as well.    For the full resolution of these problems, we need reform, which is an attempt if not to stop this process of explosive disintegration, then at least to radically regulate it and to steer it into a manageable channel.

     [Correspondent]    How does the planned scenario of reforms, associated with break-up of the sector, take into consideration the exacerbation of the problem of cross subsidization?    How can it prevent major consumers from spontaneously leaving the AO-energo and going to FOREM?    Why is it a solution to the given problem?

     [Chubays]    Reform in and of itself does not resolve the problem of cross subsidization.    By 2005, when the competitive market in electrical energy will be introduced, cross subsidization must be eliminated.    Today, not only power producers understand this, but also the leaders of the regions.    Finally, a tendency has been outlined in practically all the regions: Tariffs for industry are growing much more slowly than for subsidized groups of consumers.    In a number of cases, they have even declined.

     We favor a gradual, step-by-step resolution of this problem.    A schedule of changes in tariffs by groups of consumers must be compiled for each energy system, for a period until total liquidation of cross subsidization is achieved.    At the same time, measures for targeted social protection of specific categories of the population must be implemented.    Major consumers should not leave the energy systems during this period.    In order to reduce expenditures for electrical energy, they will have the opportunity to buy it in the unregulated sector of the wholesale market.    We have an entire set of proposals and, seeing the acuteness of this problem, we have sent them to the government.    Furthermore, energy producers will have to seriously reduce expenditures, and this will hold down the growth of tariffs.

     [Correspondent]    But prices on coal and gas will still grow?

     [Chubays]    We do not foresee any radical growth in the price of coal.    It is in fact being held down by the export price and by the export transport capacities and logistics.    Therefore, there will be some growth here, but only as a measure of inflation.    But with gas, naturally, there will be a different picture, and this also dramatizes the situation.

     [Correspondent]    Specifically what kind of situation is being formed with gas?

     [Chubays]    According to the results of 9 months of this year, gas prices rose by 40 percent--up to 70-85 rubles (R) per 1,000 cubic meters.    Our tariffs have increased by 27 percent.    That is, gas prices are growing faster than our tariffs.    This tendency will also probably be retained in the future.

     Intensity of electricity usage in various types of production


     [Correspondent]    A number of experts generally believe that reforms are being implemented in incorrect sequence: Before liberalization of the domestic gas market, liberalization of the market in electrical energy is either impossible, or will be a profanation.

     [Chubays]    The leading reform of the gas sector has its "pros" and "cons."    In any case, reform of the electrical power industry must proceed hand in hand with reform of the gas market.    On one hand, today the leading reform of the power industry is justified.    Regulated prices on gas make it possible to make a smoother transition to the market in the electrical power industry.    We will organize the market and we will attract investments into construction of modern effective capacities--primarily those based on the steam-gas cycle.    As a result of this, the consumption of gas will be significantly reduced, and the effectiveness of its application will be increased.    This is also to the advantage of Gazprom itself.

     On the other hand of course, it would be better for us to have fuel at market prices at the outset--not only coal and fuel oil, but gas as well.    For us, regulation in the gas sector means not only prices below world prices, but also limitations on provision.    Investors come to me who are ready to build gas refineries.    One of the first questions they ask is: What will happen with gas provision to these plants?    Market relations in the gas sector will give much freedom to the electrical power industry as well.

     [Correspondent]    A market with well-developed competition and supply and demand which are effectively equalized by prices is something that is very rarely seen outside the pages of economics textbooks.    In reality, many regional energy systems are monopolized either on the part of demand, or on the part of supply.    According to your plan, who will compete in them, and how?    Could you cite specific examples?

     [Chubays]    At the level of the retail, consumer market, we can cite an endless number of examples of markets with "well-developed competition," as you call it.    These are markets in many types of consumer services, the market in most food products, and gasoline.    This did not happen right away.    More than 10 years passed from the first cooperatives to today's abundance.    In the power industry, it will be faster.    In reality, we do not have that many regional energy systems which are monopolized on the part of consumers.    It is just that we have large industrial enterprises with large volumes of consumption, but in reality each energy system has thousands of consumers.    But "supply" today really is monopolized throughout the country.    But to give the consumer the opportunity to choose his electrical energy supplier--that is the market, and that is the goal of the reform.

     On the way to the consumer, it is primarily the marketing companies which will compete with each other.    They will choose which generator to buy the energy from--in their own region, in the neighboring one, or whether the sales volumes of this marketing company will generally give it the opportunity to buy electrical energy on the wholesale market.    All this will be ensured by equal access to the networks, which is also a key principle of reform.    There will be competition in such forms of business as generation (on the wholesale market between the wholesale generating companies, on the regional market--between the territorial generating companies) and marketing.    Dispatch and transmission will remain monopolized and non-competitive.    Competition in many regions will arise also between the repair and other service companies, which is very important for the power industry.

     [Correspondent]    One may often hear the following argument: Tariffs on hydroelectric power are significantly lower than on tariffs on heat, and if there are low tariffs, then why reform the entire electrical power industry?    Is it possible to resolve the problem of growth of tariffs by increasing the relative share of hydroelectric power?

     [Chubays]    Yes, in fact, tariffs on hydro-generation are several times lower than on thermal generation.    As a rule, they are 8-10, even 5, kopeks, while at thermal plants they are 30-35-40 kopeks.    This is the pure truth.    But the nature of this phenomenon is very simple: Tariffs generally do not take into consideration the cost of invested capital.

     [Correspondent]    That is, GES [hydroelectric power plants] operate as a gift of nature?

     [Chubays]    Absolutely.    This, of course, is effective from the standpoint of the current moment.    But if we look at the other side of this coin--not through the eyes of the consumer, for whom it is convenient for the present day, but through the eyes of the investor--it becomes obvious that no investor in his right mind would even discuss the possibility of investing money into hydraulic generation.    Yet it is very capital intensive, and the state will never be able to develop current hydroelectric construction without attracting private capital.

     At the same time, Russia's peculiarity consists of the fact that we have fantastic volumes of untapped hydraulic resources.    On the whole, the coefficient for utilization of hydraulic resources comprises 17 percent, and for the Far East it is 3 percent.    This despite the fact that, say, in Austria, it is 90-95 percent.    That is, our country possesses gigantic natural resources, but the economic mechanism which has been built excludes the possibility of their utilization.    It is clear that neither modernization of the existing plants, nor the construction of new ones is possible without reform of the current system.

     [Correspondent]    In discussing the project for reform of the electrical power industry, reference is often made to the negative moments in the course of privatization and the security deposit ["loans for shares"] auctions--the cases of corruption, and so forth.    Does the scheme of restructuring RAO YeES rule out such abuses?    And in general, how do the specific historical conditions of that process, as we call them, differ from the current one?

     [Chubays]    Those who utilize the argument of security deposit auctions to oppose reform of RAO YeES are being coy, to say the least.    They are being coy because they must certainly understand the fundamental difference between the Russian era of '95-'96 and the Russian era of 2002-2003.    These are different worlds and different conditions.

     The security deposit auctions resolved only one task: The creation of large capital so as not to allow the return of communism in Russia.    The task was 95 percent political, and only 5 percent economic.    It was resolved with the aid of the security deposit auctions, against whose procedure we could have legitimate claims from the standpoint of classic economic theory.    But large private property was created in the country in an extremely short time.

     Our key task today is to ensure a competitive market in electrical energy.    The market in electrical energy may be competitive when it has different owners.    If the owner of everything is RAO YeES, then there will be no competition.    It is specifically for this reason that RAO YeES must cease its existence in its current form.    Competitive owners must emerge.    That means, we must create this competition through different ownership.    Further, the question is to a significant degree technological--how this different ownership emerges.

     There are two technologies for creating wholesale generating companies (OGK), which comprise the basis of the future market, its framework.    The first way is to sell the share of property owned by RAO YeES in these companies.    The second way is not to sell this property, but to isolate wholesale generating companies from RAO YeES through the procedure of reorganization in accordance with the Law on Joint-Stock Companies, and to divide up this property in mirror fashion between the shareholders.

     Each of these ways has its advantages and drawbacks.    Since this is a sensitive and painful question for our shareholders, since some of our opponents are speculating on it by bringing up the topic of security deposit auctions, we are prepared to agree to reject the sale altogether.    We know the technology which makes it possible to really ensure pluralism of ownership in the case if we do not sell our packets in the OGK.    In that case, the structure of ownership of the wholesale generating companies would correspond to the current structure of ownership of RAO YeES--52 percent of the shares owned by the state, and the other 48 percent owned by minority shareholders.

     Capitalization of RAO YeES


     But beyond that, for me it is simply of principle importance that owners--wholesale generating companies--do not lay up this property, but that they still opt for attracting strategic investors, who may be Russian "strategists" or Western strategic companies.    This is specifically what we must achieve, in my understanding.

     The trouble is that today we have no "strategists" among the RAO YeES shareholders.    Objectively, that is how it worked out.    In my opinion, it would certainly be possible to develop a prudent technology, under which a strategic investor would nevertheless appear, even if RAO YeES rejects the sale of the share packets.

     [Correspondent]    Perhaps, as a result of reform, certain "pieces" of the sector which are potentially profitable objects really will become attractive to investors.    But who will invest in and modernize the power industry in regions with objectively high expenses and an absence of competitive generators?

     [Chubays]    We believe that, as a result of the reform, all of the "pieces" of the sector, as you call them, will finally become profitable.    The level of profitability will ultimately determine the degree of investment attractiveness.

     For non-competitive aspects of the business, the funds for development will be included in the network tariffs and dispatch tariffs.

     For isolated energy systems, and the discussion here centers specifically around them--this is primarily our Far East--the investment process will be built on different principles.    There, it is impossible to create a market in view of technological reasons.    And where there is no market, there must be regulation.    The tariffs must include the investment component.    It will be possible to attract credits.    This year, for example, we have launched 50 megawatts of capacities at the Mutnovskiy GeoTES at the expense of a special-purpose credit from the EBRD [European Bank for Reconstruction and Development].    And this is specifically a region with objectively high expenditures, an isolated system.    But, I repeat, there are few such regions--this is not a typical situation.    For example, completion of our long-term construction projects on building hydroelectric plants will immediately make it possible to significantly reduce tension in a number of such regions.    The fund for building completion and investment guarantees, which is being created, will in the future also significantly reduce the risks of investing in the most varied objects of the power industry.

     [Correspondent]    Can we hope for the appearance of a strategic investor in view of the ongoing conflict with minority shareholders?

     [Chubays]    At the end of September, the management of RAO YeES presented a set of initiatives on measures which must be implemented immediately, and proposed a real dialogue with the minority shareholders on correcting the company's strategy of development.    What we proposed, the market perceived in a positive manner: 2.5 months after this announcement, quotes on shares of RAO YeES had risen by more than 60 percent!    Not one other Russian company experienced such growth.    The market on the whole had grown by 5 percent during that time.    Practically, this means that it was specifically our growth that brought up the market.

     [Correspondent]    According to the indicator of capitalization per unit of established capacity, RAO YeES loses out by 20-30 times to the major European energy companies--the German RWE and the Italian ENI.    How can you explain this?    Is this undervaluation associated with the risk of unequal exchange of assets for minority shareholders?

     [Chubays]    In fact, our shareholders are somewhat concerned about an unequal exchange.    In September, the company's management, having announced seven steps to meet the minority shareholders halfway, once again confirmed that a principle of reform is the proportion distribution of shares in the newly created companies, at any level.

     As for the under-appraisal of our assets, here there are very many factors, and such a direct comparison is not entirely correct.    In Russia, the assets in practically any company are undervalued, and their value is incomparable with the assets of companies in the Western countries.    We have different economies, different conditions of economic management, different effectiveness, different country-related risks.    All this is contained in the quotes.    A company which operates on market conditions and a company which operates in a market economy, but under state regulation, generally cannot be compared.    But our capitalization is growing.    It is growing faster than the market.    We have removed the risks associated with the potentially possible sale of profile assets.    After adoption of the laws, a large part of the risks associated with the conditions of uncertainty in the sector will be removed.    I am convinced that we will continue to grow in the future.    It is another matter that--regardless of the conditions and regardless of the steps taken by management--any delay in reforms will not have a positive effect on capitalization.

     [Correspondent]    If we could, let us return to the economics of restructuring.    Objectively, there are different plants, and some of them are probably find themselves in very difficult conditions in terms of expenditures.    Will they be included in some more balanced structures?

     [Chubays]    One of the goals of reform is to create a situation whereby effective generating capacity attracts the investor and develops.    The ineffective one is either modernized, or shut down.    As in any sector, in the power industry the logic must be the same: Effective business grows, ineffective business is restructured or shut down.    Of course, in the power industry this is a much more delicate problem, which cannot be resolved bluntly, by throwing all the plants out onto the market and then seeing which ones survive.    It is specifically for this reason that we have proposed such a structure as the wholesale generating company.    Every OGK would include several plants, which will vary in regard to their fixed capital, fuel, and location.    The OGKs must have conditions which are mutually comparable, both in terms of average production cost, and in terms of competitive position on the market.    But at the same time, there would be different plants within the OGK.    This means that each wholesale generating company will be faced with the question which you have posed.    Within the OGK, there will be room to maneuver.    But if electrical power plants were thrown out onto the market individually--then certainly there would be problems, which could not be resolved.

     In any case, closure and withdrawal of a plant, in accordance with the draft law on the electrical power industry, are possible only through the government.    Therefore, the situation may arise whereby the interest of pure business comes into contradiction with the electrical energy balance, with the physical requirements and the statistical and dynamic stability of the entire energy system.    For example, if there is one generating capacity in a large region, and this generating capacity is shut down, energy supply to the region as a whole may be threatened, even in the presence of a well-developed network.    Therefore, provision is made here for a more complex technology of decision making.    At the same time, the state is also a shareholder in the OGK at the initial stage.    But even if it withdrew as a shareholder at some stage of reform, still the closure of the plant would be a question which is resolved only through the government, with consideration of factors outside of business.

     [Correspondent]    Could you tell more specifically about the OGK?    What are the regions of their responsibility and the generating capacities included in them?

     [Chubays]    Altogether, plans call for creating 10 OGKs: Six on the basis of heat and power plants, and four on the basis of hydroelectric plants.    Their total capacity would comprise on the order of 70,000-75,000 megawatts, around 45 percent of the holding company's capacity.    The backbone of the OGK would be comprised of our federal plants, the branch stations of RAO YeES Rossii and a number of large plants from the regional energy systems.    The list of electrical power plants which would most probably be included in the OGK is posted on the company's website.    The board of directors has approved the list of our assets which will not be sold either today or tomorrow.    That is, they will remain as assets of RAO YeES until the end of the company's existence, until the completion of reform.    This list includes the assets of the Federal Network Company and the OGK.

     As for the region, the OGK as such cannot have a region of responsibility.    The OGK will supply energy to the wholesale market.    Moreover, the OGK will include electrical power plants located in various regions, but this will be a single legal entity, a single company.

     [Correspondent]    One of the proclaimed goals of reform of the power industry is the scrapping of the expensive model of price formation in the sector, which discourages conservation of energy resources, the struggle against losses and reductions in expenditures.    Is there some assurance that the elements of competition, which will emerge as a result of reform, will lead to such a result, and on what is [this assurance] based?    After all, for example, critics of the English program of privatization and commercialization of the power industry insist that the reduction of energy tariffs in England was the result not of competition as such, but of the decline in prices on gas and coal and the mass lay-offs of workers in the sector, which just happened to coincide in time.

     [Chubays]    When there is a market, every producer will be vitally interested in reducing the cost of production.    The profit of the company and its development will ultimately depend on this.    This is the law of the market.    Already today, all of the enterprises in the holding are successfully implementing programs of cost management.    In only 9 months of this year, the savings were over R9 billion, and last year--over R12 billion.    These are huge sums.    For comparison: The net profit of the holding company last year comprised R14 billion.    Today, when the government decree permits leaving the savings in the tariff for 2 years, this may already become a serious incentive for cost cutting.

     As for the English reform of the electrical power industry, there the situation is entirely different.    There, many events have been superimposed over one another.    Reform in England began in the late 80's, and proceeded parallel with reform of the coal sector.    In both sectors, there was a significant reduction of personnel.    In the power industry, it was by almost 30 percent.    In the coal sector, most of the unprofitable mines were closed down.    At the same time, power producers were allowed to burn gas, which they could not do before.    Gas was considered to be the raw material for the chemical sector, and not a fuel.    That is, the fuel balance changed drastically.    Construction of effective modern gas installations was developed.    Parallel with this was the development of the market.    At practically the same time, new capacities and a market emerged, as a result of which prices declined.    Then, England exports electrical energy, primarily from France, and also on a competitive basis.    Therefore, if we are to give an appraisal to English reform, we must take into consideration the full totality of facts and to tie them in with one another.

     [Correspondent]    When modernization of generating companies and networks begins, RAO YeES will inevitably present a colossal demand for products of energy machine building, metallurgy, and construction.    Is there some way to appraise the effect of this demand on the part of RAO YeES on economic growth?

     [Chubays]    The logic is absolutely correct, although few people see it.    The fact is that already, the very fact of restoration of 100-percent payment for electrical energy and heat has led, among other things, to the situation that our entire investment process is also being financed by real money, and not by mutual offsets.    And while, 3 years ago, we financed only 5 percent of the construction of the Bureyskiy GES [hydroelectric plant] with real money, and 95 percent with offsets and other schemes, today we are giving 100 percent in real money.    Where has all this led?    As far as I know, for example, the Leningrad Metals Plant last year posted a growth of 60 percent in its volumes.    These are turbines for that same Bureyskiy GES and for an entire series of our other plants.    However, they are also working well for export at the present time, but the fact of growth of our orders is obvious.    That is, already today, simply as a result of clearing up the company's financial flows and bringing about order with budgeting and payment, we have become a most interesting and profitable market for our machine builders.    Moreover, we, of course, retain competition, but with all other conditions being equal, we give the priority to domestic developments.    For example, the GTE110 gas turbine is an absolutely key element in the entire strategy for future technical retooling of Russia's power industry.    It is clear that our entire gas energy sector (and gas in our country's balance comprises 68 percent) must be fully retooled from the traditional steam-power to steam-gas assemblies.    These are gigantic orders for machine builders.

     [Correspondent]    Why was another, smoother, approach to overcoming the investment crisis in the sector not selected?    For example, one based on pinpoint project financing of modernized facilities with participation of the state, domestic producers of energy equipment, and major energy consumers?

     [Chubays]    In 10 years, RAO YeES Rossii has introduced 207 energy units, with total capacity of 11,200 megawatts.    Construction was performed under the most difficult financial conditions, within the scope of meager investment funds.    The state is incapable of providing those volumes of investments, which are already today needed by the electrical power industry.    Today, we are capable to retaining the production potential, but the wear of capacities is increasing.    Specialists have estimated that, at this rate, we will renew our capacities in approximately 250 years.    For this year alone, our repair program will cost R40 billion.    This is a huge amount of money, and this is not renovation--it is merely patching up the holes.    The question of obsolescence of equipment and technologies still remains.    We see the solution in bringing strategic investors--Russian as well as foreign--to the sector.    The goal of reform consists specifically of forming companies which are attractive from the investment standpoint, in order to minimize the investment risks.    And none of us think that the appearance of "strategists" will be rapid.    This approach will specifically be smooth, well thought-out and well planned.    It will take decades to fulfill.

[Description of Source: Moscow Ekspert (Internet Version-WWW) in Russian -- Weekly business magazine known for its reporting and analysis of financial-industrial groups and their political interests, partly owned by Vladimir Potanin.]




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