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Putin's Adviser Illarionov Views Electric Power Industry Reform Issues -- Part 1

CEP20030115000535 Moscow Rossiyskaya Gazeta in Russian 14 Jan 03

[Part one of article by Russian president's economic adviser Andrey Illarionov: "Substance of Reform Is More Important Than Its Pace" -- taken from HTML version of source oprovided by ISP ]

[FBIS Translated Text]
The electric power industry can be compared to the nervous system of the economy and its reform can be compared to a surgical operation on the nervous system.   Reform in the economy, just as an operation in medicine, is occasionally a useful and necessary step.   However, in both cases one has to realize clearly what part of the currently functioning system one finds unsuitable; what components of the existing system pose the greatest threat; what problems the planned reform (operation) is expected to solve; how exactly it should be carried out and what the sequence of steps should be; what results it should produce, what optional scenarios exist and what risks each of them entails; what conditions should be met to ensure that it is successful; is it possible (and to what extent) to solve the problem by means of therapeutic methods.   There are a lot of questions regarding reform of the electric power industry.   These questions have been repeatedly asked in our society in recent years; they have been asked by deputies, senators, representatives of the legislature and the executive, in Moscow and in the provinces, by power engineering specialists and many citizens of our country.   However, by far not all of those questions have been answered.

Tariffs are one of the questions to which this country has not received convincing answers (the price of electricity and the tariffs at which electricity is and will be sold to consumers).   What do we hear all the time?   We hear that electricity tariffs are understated and should at least be doubled.   Why?   We hear a whole number of reasons in response.   In particular, we are told that our electricity tariffs are lower than in other countries of the world.   Of course, this immediately prompts the following question:   Why should we compare our electricity prices to prices in other countries of the world?   In view of physical properties of electricity its commercially efficient transportation is limited to a certain distance (economists call those kinds of commodities "limited tradability goods.")   Therefore, electricity does not have a single world market or a single world price.   Electricity is sold on local markets where prices are set depending on the existing correlation between demand and supply.

The correlation between the demand for and the supply of electricity in Russia differ substantially from the relevant correlation in foreign countries.   Therefore, it is not quite correct to directly compare nominal electricity prices in countries that do not have interconnected energy systems.   As for the level of Russian prices itself, it is only natural to assume that in light of the rather low income level (in dollar-equivalent terms) and a substantial surplus of power generated in Russia the correlation between the low demand for electricity and its substantial supply should result in much lower electricity prices than in many other countries.   Direct comparison of Russian nominal prices for electricity with prices in other countries of the world attests that they are much higher than their face value.

For instance, industrial consumers in the United States and Germany pay 4.1 cents per one kilowatt-hour of electricity, in Canada -- 3.8 cents, and in France -- 3.6 cents.   In Russia, the price is 2.1 cents, meaning, is 1.5 times lower or even twice as low as in developed countries.   However, per capita income in Russia in dollar-equivalent terms is approximately 15 times lower than in the United States, Germany, Canada, or France.   Therefore, the correlation [between Russian and Western] electricity prices should be much greater than 1.5 or 2.   If so, Russia's current electricity prices are overstated and not understated.   And, most likely, they should be lowered and not increased.

Let us compare the correlation between domestic Russian and world (regional) prices for some stock exchange commodities that have their world (regional) markets and world (regional) prices.   Russia's domestic oil price oscillated within the range of 20-30 percent of the world price.   The domestic price for residual fuel oil oscillated between 15-20 percent of European prices.   Meanwhile, electricity prices stood at 40-50 percent of prices in developed countries.   It appears that prices for commodities that are not imported as massively as stock exchange commodities ("limited tradability commodities" that do not have either a world market or world prices) are closer to prices in developed countries than prices for "tradable" stock exchange commodities.   This contradicts both economic laws and the world practice and means that Russian electricity prices are overstated.   If we compare electricity prices in Russian Federation regions and prices in foreign countries, it will turn out that in six regions of this country (the Republics of Kalmykia and Yakutia, Arkhangelsk, Kamchatka, and Sakhalin Oblasts, and Chukotka Autonomous Okrug) electricity prices are already higher than prices in France, Finland, Norway, and New Zealand.   Meanwhile, we have to reiterate that Russia is after all a country with a different, lower, per capita income level in dollar-equivalent terms than the aforementioned countries.

Finally, if one wants to make legitimate comparisons to foreign countries, one has to take into account how much particular countries as a whole spend on electricity and how much all national consumers -- the industrial sector, the population, and municipal structures pay for electricity.   In the United States, for instance, all payments for electricity comprised 3 percent of GDP in 1990, 2.3 percent in 1999, 2.2 percent in 2000, and 2.1 percent in 2001.   In the second half of the nineties, the correlation between all electricity purchases and GDP was as follows:   In Finland -- 3.2 percent; Sweden -- 2.5 percent, Italy -- 2.4 percent, Brazil -- 2.3 percent, Austria and Switzerland -- 2.1 percent, Germany -- 1.8 percent, Great Britain -- 1.7 percent, France and Denmark -- 1.6 percent, Mexico, Indonesia, and Ireland -- 1.5 percent.   In the overwhelming majority of countries total electricity purchases stood at 1.5-2.5 percent of GDP.   Let us now look how much Russian citizens and Russian companies paid and pay for power.   In 1995 -- 6.8 percent of GDP, 1997 -- 8.2 percent, 2000 -- 4.2 percent, 2001 -- 4.7 percent, and 2002 -- almost 5.5 percent of GDP.

The increase in the correlation between the monetary equivalent of electricity sales and GDP took place not as much due to the increase in actual consumption of power (it went up 1.7 percent in 2002-2002 from 864 billion kilowatt-hours to 878 billion kilowatt-hours) as due to a price increase (by 53 percent from 1.27 to 1.94 cent per one kilowatt-hour).   In Russia this indicator is already 2.5-3 times higher than in the United States and in many other countries of the world.   Therefore, payments for electricity in Russia, as compared to incomes, are higher than in countries that by far are not the poorest countries in the world, countries where per capita electricity consumption is several-fold higher than in our country.   Moreover, in those very rich countries electricity costs are two, three, or even four times as low as in other countries.   Why?   The reason is that prices at which electricity is sold in Russia are not understated; they are overstated as compared to our GDP, the level of our development, and the level of our incomes.

Nevertheless, we hear all the time:   "The existing electricity prices are insufficient.   Tariffs should at least be doubled."   This means that those who advocate a tariff increase believe that the 5.5-percent correlation between electricity costs and GDP is insufficient and that tariffs should be doubled as a minimum.   In its turn, this means that the existing three-fold or four-fold difference between electricity payments in Russia and in foreign countries [as compared to GDP] should probably become six-fold or eight-fold difference.

We are told that electricity tariffs should be increased because outlays are growing.   In particular, Anatoliy Chubays, chairman of YeES Rossii RAO [Unified Energy System of Russia Russian Joint-Stock Company] Management Board, said in his recent interview that tariffs should be raised because the price of residual fuel oil (fuel used by electric power stations) grew significantly over the last several months.   The price of residual fuel oil, indeed, increased 2.5-fold in February-November 2002.   However, on the one hand, this does not automatically mean that prices have to be raised.   Prices of raw materials change all the time, but this does not mean that prices of goods and services produced from those raw materials should increase accordingly.   More than 100 countries of the world import oil, the price of which has tripled since 1998.   However, dollar prices of their products have changed unsubstantially.   The concept of a rigid correlation between outlays and prices is a vestige of obsolete Marxist theories and was inherited from the economy managed by the [USSR] State Planning Committee.

Second, life did not start in February 2002.   It is no accident that the YeES Rossii management prefers not to tell what the situation was before that date.   The point is that over the year and one-half before February 2002 the price of fuel oil dropped 2.5-fold.   Therefore, in two years -- from November 2000 to November 2003 it increased 5 percent in ruble-equivalent terms (from 2,429 to 2,552 rubles [R] per tonne).   Meanwhile, when converted into dollars in line with currency exchange rates, the price of fuel oil dropped 8 percent from $87.4 to $80.4 per tonne.   Therefore, electric power stations currently pay for fuel oil 8 percent less in dollars than they paid two years ago.   Over the same period of time the price of electricity increased 59 percent in ruble-equivalent terms and 39 percent in dollar-equivalent terms.   Two years ago, one kilowatt-hour of electricity was sold at R0.42 and now -- at R0.62; two years ago it cost 1.5 cents, and now, it costs 2.1 cents.   Is this the way to justify further increases in electricity tariffs?

The country is being told that prices have to be brought up for two-three years until 2005; an electricity market will have be established by that time and then, electricity prices will drop.   Why will they drop?   The YeES RAO leader says that this will happen in line with the economic law on the correlation between demand and supply.   In line with the law, even in 2005 the supply of electricity in Russia will remain much higher that the demand due to the huge surplus of generating capacity in this country.   As a result, prices will drop.   If it really is so and if in 2005 -- despite the expected further growth of GDP and possible withdrawal of a proportion of generating capacity -- the supply of electricity greatly exceeds the demand thus causing the lowering of prices, it is true today ever more so.   The question is:   What sense does it make to raise prices now?   Any economic sense is not discernible.   Ya. Urinson, deputy chairman of YeES Rossii Management Board, stated the following in his interview:   "The tariff increase will make us richer, not poorer."   This statement is difficult to dispute.   Tariff increases will, indeed, make Mr. Urinson and other YeES Rossii managers richer.   However, all other people in this country will become poorer.   Administrative increases of electricity tariffs have become a fine-tuned mechanism for channeling huge financial resources from the nonmonopoly to the monopoly sector of the economy.

According to Investitsii Strane, Russia cannot do without foreign investors, the electric power industry needs investment, and $50-60 billion should be invested in generating capacity within the next decade.   Should it really?   Let us analyze the cited arguments:   Even in 2005 Russia will still have a substantial surplus of capacity in the generating sector, which will result in excessive supply of electricity as compared to the demand and will lead to the inevitable drop of electricity prices.   However, since the surplus of generated electricity currently stands at no less than 35 percent of existing capacity, since the surplus will persist even in 2005, the question is:   Who needs investment in excess capacity?   Judging by the dynamics of decommissioning of generating capacity, our country will probably not need large-scale investment in the power generating sector for quite long.   Potential investors are aware of this and therefore are in no hurry to invest in the generating sector.   Perhaps, they could invest in the Russian electric power industry (admittedly, in networks rather than the generating sector).   However, they are not allowed to, although the density of electricity supply networks in Russia is insufficient, there is a shortage of networks, and the networks are operating at a loss.   To eliminate weak points in the electric power industry, link regions that have an electricity surplus with regions experiencing power shortages, increase the density of networks, heighten stability and reliability of electricity supply to customers -- these are really grandiose and advantageous tasks for investors, both Russian and foreign, private and state-run, individual and corporate.   However, there is a ban on investment in networks.   Who imposed it?   YeES Rossii RAO.

The ban remains in force in the package of draft laws on the electric power industry currently under discussion in the State Duma.   Even if some courageous person carelessly decides to invest in new electricity supply networks he will have to part with them when the construction is completed.   The point is that the package of draft laws on the electric power industry, which is currently being discussed and has been approved in its first reading, prescribes that networks should be transferred under YeES Rossii's management.   Does anybody really believe that it is the way to attract investment?   Therefore, a potential investor analyzes the situation and waits.   He carefully examines the economic and technological parameters of the use of resources in Russia's electric power industry.   He compares electricity prices in Germany and Russia:   4.1 and 2.1 cents is a two-fold difference.   He compares prices of gas used to generate electric power:   $250 and $17 per 1,000 cubic meters -- a 15-fold difference.   He compares wages in Germany and Russia -- almost a 15-fold difference.   The potential investor notices the following oddity:   Power generation costs in Russia are 15 times lower than in Germany, but prices are only twice as low.   Perhaps, technologies in Russia are not as good as in Germany and equipment is older and more worn-out?   But not seven times as old, after all!   After all, the generation of one kilowatt-hour of electricity does not require seven times as much gas, and the staff of comparable electric power stations is not seven times as big as in Germany!   Therefore, the potential investor concludes, the huge funds obtained from the sale of electricity in Russia are not spent in the electric power industry; they are spent elsewhere.   "Perhaps, they are spent on investment?" the potential investor wonders.   "Or perhaps they are used to build new stations and networks and renew the equipment?   After all, it has been repeatedly said in recent years how important and necessary it is to attract investment."   And then, the potential investor looks into YeES Rossii's financial reports.   What does he see there?   He sees that if 1997 -- the last year before the new management's arrival -- is chosen as the starting point, investment in the company dropped 54 percent over the past five years.   The investor then asks a natural question:   Is the entire Russian electric power industry affected by this kind of large-scale investment crisis?   But then he looks into other companies' financial reports and sees that the crisis was very selective:   He affected YeES Rossii RAO only.   Nothing of the kind has been observed in other Russian companies.   For instance, investment has more than doubled in another electric power company -- Rosenergoatom.   And then, the potential investor starts to realize that people in one company are preoccupied with real investment, whereas people in the other company are busy waging PR campaigns to advertise investment.   The investor analyzes data on investment in the entire country and sees that investment in the economy as a whole increased 18 percent over the five years and that investment in the industrial sector as a whole increased 20 percent.   And there is only one Russian company in which investment was more than halved.   The investor then starts to realize he is dealing with a very unusual company, which greatly differs from the rest of the Russian economy.

Production and Employment.

The investor then asks:   How did production volumes change over the years?   He realizes that over the past five years YeES Rossii's production dropped 2 percent, whereas Russia's GDP increased 19 percent and industrial output increased 29 percent over the same period.   The same trend persisted last year:   YeES Rossii's production dropped almost 3 percent, Russia's industrial production increased 3.7 percent, and GDP increased 4 percent as a minimum.   The potential investor asks questions about the dynamics of changes in YeES Rossii's workforce.   He sees that by all reporting standards -- both Russian and international ones -- the number of people working in the company increased over the past years, whereas in Russia's industrial sector as a whole it dropped.   The potential investor asks questions about the dynamics of labor productivity in YeES Rossii.   He finds out that it dropped 14 percent over the past years, although in the economy as a whole it increased by 8 percent and in the industrial sector -- by 33 percent.   The potential investor analyzes electricity losses in supply networks and finds out that five years ago they stood at 10 percent of the total volume and now -- at 12 percent.   Naturally, the investor asks questions to which he and the whole country for that matter has not received answers for several years now.


Nevertheless, the careful investor continues his investigation.   He asks about other economic indicators of the electric holding company's operation, for instance, electricity export.   How many times the investor heard from the YeES RAO management in recent years that the export of electricity is the company's strategic goal!   Remember the modernization slogan "Instead of selling raw materials sell electricity -- a commodity with a high added value?"   So many plans were adopted in this regard!   So many visits were paid to Europe, Turkey, China, and Japan!   What is the result?   Virtually all rivals have been squeezed out of this business in recent years and therefore, YeES Rossii's share in Russian electricity export increased from 60 to 92 percent.   However, the result proved to be depressing.   In 1997, Russia exported 22 billion kilowatt-hours of electricity and in 2002 -- 17.9 billion or 19 percent less.   In 1997, the value of export was $630 million and in 2002 -- around $300 million or 52 percent less.   The price of one kilowatt-hour of exported electricity dropped from 2.9 to 1.7 cents, meaning, by 41 percent.   Naturally, the potential investor wonders:   How come five years ago, when the company had a different management, it managed to export almost twice as much electricity at prices that were almost twice as high?   How come prices in importer countries have changed insignificantly, but the price of electricity exported by YeES Rossii dropped?   How come Russia's domestic electricity tariffs are growing, whereas export tariffs are falling?   Or on the contrary:   Since export prices are falling, why are domestic prices growing?   There is no answer.   Of course, the following answer is also possible:   Since export prices are falling, domestic prices have to be raised to compensate the losses.   Meaning, when it is difficult to retain positions on foreign markets it is easier to squeeze out tariffs set by the state inside the country.   But then the investor realizes that what he sees is not as much high-quality business management as high-quality lobbyism.   The curious investor has more and more questions.   For instance, why Russian electricity exported to Kazakhstan is cheaper than the lowest domestic wholesale prices charged on FOREM [Federal Wholesale Market for Electricity and Generating Capacity]?   Why are prices of electricity exported to Azerbaijan twice as low as prices charged on FOREM for electricity generated in the nearby Caucasus regions, which, as a matter of fact, supply electricity to Azerbaijan?   Is it not strange that while Georgian authorities provide information about the volumes of electricity purchased from YeES Rossii and about the sums of money paid for it YeES Rossii reports figures that are five-ten times lower?   There are no answers.   Potential investors are greatly perplexed and, naturally, do not rush to invest their money in this kind of company and this kind of electric power industry.

[Description of Source: Moscow Rossiyskaya Gazeta in Russian -- Government daily newspaper.]

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