By Laura M. Brank and Peter Gloushkov

The Russian government approved an ambitious plan in late May to restructure the national electric utility, RAO Unified Energy Systems.

However, many details of the plan are still in flux, and the government has set a deadline of June 19 for a working group to report back.

The restructuring is expected to occur in two stages. In the first stage, 32 power stations belonging to UES will be divided among five to seven new generating companies, and 73 regional subsidiaries of UES will be consolidated into a smaller number of entities. UES itself will become the core of a new state-owned company that will own the national grid.

UES management estimates that it needs $35 billion in new investment over the next nine years to keep up with demand for electricity.

A report released in May by Arthur Andersen — consultants for the Russian government — warned that there will be severe shortages of electricity by the winter of 2002-2003 unless a radical overhaul of UES is undertaken soon.

Background

Russia’s power sector is one of the world’s largest, with nearly 200 gigawatts of nameplate capacity and three million kilometers of high-voltage transmission lines. The sector is incorporated and consolidated primarily under one entity — UES — which accounts for over 72% of Russia’s electrical power production. UES also owns the high-voltage transmission grid and central dispatch systems, as well as between 14% and 100% of the shares in Russia’s 73 regional energy companies — called Energos — and 32 federal generating stations. Together with UES, these companies are referred to as UES Holding, one of the largest holding companies in the country, operating through six unified energy systems: Northwest, Central, Middle Volga, Urals, Northern Caucuses and Siberia. In addition, UES owns 59 research and development institutes, 30 dispatch companies, 22 “non-profile” companies — those not involved directly in the energy business — and construction, repair and other support companies. These companies, plus UES Holding, constitute the UES Group of Companies.

The market capitalization of UES has reached $4 billion with annual sales of $10 billion, according to the latest data published in March.

Given the size of UES and the scope of its activities, its privatization and restructuring have been a major topic of discussion among project developers and lending institutions with an interest in Russia.

Recent operating statistics from UES may also increase the value of its assets in comparison with previous years. For instance, UES reports that power consumption in Russia is increasing. In 2000, the consumption level rose by 3.9%, and an additional increase is likely in 2001. Anatoly Chubais, the chief executive officer of UES, said that UES managed last year to obtain 100% of its payments in cash. In previous years, including as late as 1998, the cash payment rate was as low as 20% with other payments being made through barter arrangements or through the “shadow” economy. These payment problems discouraged developers and banks from investing in Russian power projects and, as a result, almost no investment has been made in the sector in the last 10 years.

Legal Framework

UES was established in 1992 by the Russian Committee for State Property Management. In May 1998, the Duma passed Law No. 74-FZ, which restricts ownership by foreign states, companies and individuals of shares in UES to 25% of all types of shares. The same law established that 51% of the shares of UES must remain federal property and may not be sold, pledged or otherwise disposed of. The Russian government currently owns approximately 52% of the outstanding shares of UES.

Electricity Tariffs

Wholesale power in Russia is sold on a federal wholesale market called “FOREM.” FOREM functions on the basis of an April 1995 law called Law No. 41-FZ and Resolution No. 793 that the federal government issued in July 1996. All power produced by the generating companies of UES and other producers — like the nuclear power plants that are outside the UES umbrella — is supplied to FOREM, where it is then purchased wholesale.

The principles for establishing power tariffs were first outlined in a government resolution No. 121 in February 1997 and were modified by a presidential decree No. 889 in July 1998 and a government resolution No. 915 in August 1998.

Tariffs are set by the Federal Energy Commission, or “FEC,” the state regulatory authority for the energy market. In establishing tariffs, the FEC must ensure — among other things — full compensation of the established costs of power producers along with a return on profit necessary for “self-refinancing.” However, in practice, the process for establishing tariffs remains very bureaucratic, heavily influenced by state policy, and non-transparent. Real market conditions are generally not taken into consideration.

The fact is that no real market for power exists in Russia today. Even UES admits that FOREM is not a real market, as sellers are forced to sell power to buyers designated by UES who are largely related to UES.

Restructuring Plan

The plan adopted in principal by the government in late May resembles in part a restructuring proposal that Chubais floated late last year. That plan came under fire from minority shareholders and the Russian communist party who complained that it would “strip the most valuable assets of UES” and deprive shareholders of control over the company.

Details are still in flux.

Arthur Andersen, which has been advising the government, made its recommendations in a report on April 9. Arthur Andersen recommended that the restructuring take place in two stages. In the interim phase, which should begin this year, UES would become a temporary holding company to be created on the basis of UES’ current assets and containing several new structures, while retaining UES’ current shareholders.

The temporary holding company would own a grid company, a separate holding company uniting the power stations, between one and five federal generating companies, a thermal power station holding company and up to seven guarantor energy suppliers.

The federal generating companies would include those stations currently wholly owned by UES and the largest thermal stations. The stations, classified as subsidiaries of the generating companies, which form the foundation of the electricity market, would be able to charge market prices, and their activities would be licensed.

The thermal power station holding company would include the rest of the power stations. The guarantor suppliers would receive the distribution arms of UES’ current subsidiaries, but the Russian government would continue to set tariffs for these suppliers. The grid company would own the high-voltage transmission lines and dispatch facilities.

During the transition, the UES temporary holding company would own between 51% and 100% of all of the above structures. In the second phase, the temporary holding company would be liquidated and its controlling stakes in the various structures, except for the grid company, would be sold.

The Russian government would retain at least a 51% stake in the grid company, which would remain a monopoly. Shares in the grid company would be swapped for UES preferred non-voting shares.

Under the Arthur Andersen plan, shareholders of all UES subsidiaries would be offered the opportunity to exchange their shares for shares in the new companies. Shareholders of UES would receive shares in each of the federal companies, in each guarantor supplier, in the power station holding company and in the grid company, in proportion to their shares in UES. It is unclear how long this transitional phase will last.

Shareholders in the UES regional subsidiaries are also expected to receive shares in these companies. The plan provides that each new company established would present the minority shareholders of its subsidiaries with specific schemes for exchanging shares six months after establishment of such company.

The Arthur Andersen plan calls for creation of three power markets. The first, the federal market, would deal with the export of power. The second, the guaranteed market, would operate using regulated tariffs. The last, the independent market, would operate on market prices.

The power market would be regulated by a new federal body, which would be in charge of licensing power companies. The Arthur Andersen plan provides that a restructuring would last as long as seven or eight years. It would not be expected to require an increase in current tariffs.

In addition to the Arthur Andersen plan, a working group of the State Council headed by Victor Kress, the governor of the Tomsk Oblast, prepared a proposal that was presented to the Russian president at the end of April. Details of this plan remain mostly unclear. UES itself is also being advised by various consulting firms on different options for restructuring.

At the meeting on May 19, 2001, the Russian government provisionally approved the main principles governing the reform of the electricity market in Russia as set forth in a plan proposed by the Ministry of Trade and Economic Development drafted on the basis of submissions from UES and Arthur Andersen. However, due to certain discrepancies between this proposal and the proposals of the working group of the State Council and the Ministry of Energy, the full restructuring plan was sent back for further revision and additional input from the working group of the State Council.

The government requested that the final version of the restructuring plan be submitted for approval by June 19, 2001.

Andrei Sharonov, deputy minister of trade and economic development, confirmed that in the second phase of its restructuring, UES would be separated into two entities: grid and non-grid holdings. The state would own 52% in each entity (which reflects the current ownership structure of UES), and it would eventually increase its stake in the grid company. Non-grid holdings would include five to seven generating companies, and 40 to 60 wholesale-distribution companies. According to various reports, state control over the grid was one of the main issues discussed at the May 19 meeting. Under the Arthur Andersen proposal, the federal grid company would remain a state-owned monopoly. Local grids would be merged with the federal grid company. At the same time, the state would decrease its stakes in regional generation companies. Sharonov also noted that reform of the power sector will likely require that significant legislative amendments be adopted.

Interestingly, Chubais, who was present at the Russian government meeting, said that March 31, 2004 was set as the date when UES will “end its existence.”

Whatever plan is eventually adopted, it seems clear that significant attention is now being paid to this issue and that a certain momentum exists in the Russian Federation in favor of restructuring UES.