Privatesector P U B L I C P O L I C Y F O R T H E Note No. 139 April 1998 Reforming the Russian Electricity Sector Margaret Wilson In early 1997 the Russian government approved in principle the now common model of electricity sector reform: vertically separating generation, transmission, and distribution; introducing competition where possible; strengthening the regulation of functions less amenable to competition; and divesting government ownership. This model has been implemented in many countries, and the story of the reform would be relatively routine if not for special characteristics of the Russian power system: its size, diverse ownership, high level of nonpayments, and the combined heat and power role of many generating plants. This Note outlines the challenges posed by these characteristics and reports on reform achievements so far. The first challenge to reform is the sheer size smaller than the United States and Canada com- and scope of the network. The Russian power bined (table 1). Most of the generation capac- system consists of more than 200 gigawatts of ity is thermal (70 percent), with hydro (20 generation capacity, most of it interconnected percent) and nuclear (10 percent) making up by 2.5 million kilometers of high-voltage trans- the balance. Regionally, however, there are mission lines spanning an area only slightly major differences. More than 50 percent of the hydro capacity is in Siberia and the far east, TABLE 1 THE RUSSIAN ELECTRICITY SECTOR while 80 percent of the nuclear capacity is in the central (Moscow) and northwest regions. Size More than 200,000 megawatts. Generation 827 billion kilowatt-hours (kWh) (1996). The regions jealously guard their hydro capacity. Fuel mix 45% gas, 20% hydro, 18% coal, 10% nuclear, 7% oil. They regard it as a source of low-cost power for local industries and have little desire to see Demand mix 50% industrial, 11% residential, 39% other it blended into a national power supply. More- (including services and agriculture). over, the system was originally designed to Tariffs Industrial: more than US$0.05/kWh, residential: provide a fairly high degree of regional self- US$0.02/kWh, with large regional differences. sufficiency (transmission links between regions Investment Low, financed through cash flow. Almost no debt are often weak), and in many cases large parts or external equity finance or private project of these self-sufficient regions are now in other countries. The main dispatch center for the development. northwest region, for example, was in Riga (now Collections 11% cash, 59% noncash, 30% unpaid. in Latvia), and one of the primary transmission Employees 921,000 (1996). lines from the central region to the Caucasus region passes through Ukraine. Note: Data are for 1997 except where otherwise specified. Source: UES and Russian Federal Energy Commission. Consequently, restructuring generation to create a competitive market is not a straightforward The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network Reforming the Russian Electricity Sector FIGURE 1 OWNERSHIP STRUCTURE OF THE RUSSIAN ELECTRICITY SECTOR Government in most of these new enterprises, however. The government also divested part of its holding in RAO EES Rosenergoatom UES. It now owns about 52 percent of the shares, Rossii (UES) 9 nuclear stations foreign companies hold about 28 percent, and 52% government owned 100% government owneda Russian companies and individuals, including company employees and managers, own the bal- High-voltage Local generation ance (figure 1). Generation transmission and distribution companies network 34 plants companies As a result of this decentralized ownership, the 100% UES owned 72 Energos 49–100% UES owned restructuring program requires the support of 49–100% UES ownedb a wide range of stakeholders. The Energos in a. One nuclear plant is owned directly by the government. particular need to be persuaded of the ben- b. UES ownership in three Energos is less than 49 percent. UES and the federal government have no ownership in two Energos. efits of change, since they own or manage more than 60 percent of installed capacity. The Energos regard the move to a competitive process. Regional opposition, combined with wholesale market as a threat to their autonomy, serious risks that technical constraints will al- a change that will end their control over dis- low generators to game the system and extract patch and oblige them to purchase high-cost monopoly prices, has led the government to power from the market rather than distribut- adopt a cautious timetable for moving to a com- ing low-cost power from their own plants. Some petitive market. of the Energos understand that their power would be dispatched first and that they would Diversified ownership receive the system marginal price for it. But they remain concerned about nonpayments on The second challenge lies in the electricity the wholesale market and about having to pay sector’s ownership structure. While many coun- market service charges to sell and repurchase tries began reform with a vertically integrated, what they regard as their own power. state-owned monopoly, the Russian govern- ment in 1996 faced a sector that had already Outside shareholders of UES also will have to been partially restructured and privatized. Un- be persuaded of the merits of restructuring, par- til 1992 the electricity sector had been orga- ticularly with regard to any divestiture of gen- nized in vertically integrated companies, called eration assets. While these shareholders would Energos, in each of the seventy-two oblasts or theoretically retain an equivalent ownership regions. But when mass privatization began that stake in newly formed generation companies, year, the federal government moved to main- they might not perceive these holdings as tain its control over the power sector. equivalent in risks or returns to their existing holdings in an integrated UES. The government formed a new company, RAO EES Rossii (commonly referred to as Unified En- Nonpayments ergy Systems, or UES), and gave it ownership of the country’s largest hydro and thermal gen- The third challenge is nonpayments. The root erating stations (nuclear excepted), the high-volt- causes are many. They include tax avoidance, age transmission network, and the dispatch profiteering on barter settlements, legal and po- systems. The Energos were set up as separate litical barriers to cutting off supply to “strategic” companies to own and operate the smaller gen- customers, and simple failure by the government erating plants and the distribution networks, and to collect adequate taxes or introduce sufficient some of their stock was sold to employees and spending discipline to ensure that energy sup- managers under the voucher privatization pro- plies to budget-funded agencies can be financed. gram. UES retained at least a 49 percent interest The lack of cash payments has jeopardized the financial viability of many power sector enter- restructuring the electricity sector and has prises, hampering their ability to introduce or defined further steps as part of its 1998 program maintain efficient operating systems or to respond for economic reform. In 1997 the emphasis was to changing market conditions. Moreover, barter on consolidation at the center, with the federal and other noncash instruments are an inefficient government strengthening its governance of the and costly basis for market transactions. electricity sector and bringing new management into UES. The new management team has fo- Restoring payment discipline is key to moving cused its initial efforts on restoring the company’s forward with the proposed restructuring and un- financial viability. To this end, bundling of the sector. Without this discipline, ▪ New financial controls and audit procedures many of the newly formed enterprises would were introduced. UES and ten of the Energos risk financial failure, which would both discredit are being audited, and UES is moving to full the reforms and invite renewed government in- IAS accounting. tervention. Nonpayments can be fully resolved ▪ The investment program has been reviewed only at the interface with the customer, how- and rationalized, and funding withdrawn for ever, which is typically through the regional dis- about forty projects deemed nonviable. tribution company. Thus the federal authorities ▪ Collections have been improved, increasing cannot unilaterally address the problem, but cash payments to the UES transmission divi- must work through local entities. sion by 250 percent and overall cash pay- ments from 5 to 20 percent of revenues. Competition and regulation ▪ New sources of capital are being explored, including private sector participation in The fourth challenge lies in the fact that many planned new investment projects and a pos- of the generation assets controlled by the sible convertible bond issue for placement in Energos are combined heat and power plants. international financial markets. These plants were built primarily to meet local heating demands and are an integral part of the The government has also taken initial steps to extensive district heating networks that in many introduce competition. It created an indepen- large cities serve the majority of the population. dent financial operator to establish a competi- In the absence of competitive heating markets, tive wholesale market among large industrial heat prices for these plants are regulated by lo- customers and generators. Model contracts cal authorities, generally at a level equivalent to were established for transactions, using the net- the cost of heat-only boilers. Regulators and mu- work as a common carrier. Principles for ac- nicipalities are concerned about the integration cess to the transmission and distribution of competitive and regulated activities in a single networks and for regulation of wheeling tariffs entity, about the implications of this under the are being established. A wholesale market, current procedures for allocating joint and com- being piloted in one region, counted two mon costs, and about their ability to ensure that generators and four customers among its par- the Energos do not use the regulated heat mar- ticipants by the end of the year. To participate, ket to extract windfall profits from electricity buyers must agree to pay cash, in advance, cogeneration. With the system of regional regu- and to eliminate payment arrears. In return they lation still in its infancy and many of the local receive a 35 percent discount on tariffs. regulators lacking experience and expertise, this added complexity is a serious concern. The government has also undertaken to reorga- nize generation, to boost operating efficiency Achievements to date while laying a foundation for a competitive gen- eration market. It has evaluated several Despite these challenges, the government has restructuring options in recent months, and the taken meaningful steps toward reforming and 1998 program calls for finalizing and initiating Reforming the Russian Electricity Sector the reorganization plan. Among the options is The reorganization of generation, particularly grouping the existing plants into generating com- the increased focus on competition among sup- panies, or Gencos, to create enough potentially pliers, is also expected to reduce electricity viable, independent entities for a competitive prices. As new generating plants begin to com- market. Finally, the government has begun re- pete with existing plants, investment proposals moving electricity pricing distortions, increas- are expected to become more rational and out- ing tariffs to households by 32 percent and of-date, inefficient units are expected to close making a commitment to eliminate cross- (plans for their closure are to be developed, subsidies by 2000. including programs to mitigate social impacts). Next steps Electricity prices still need to be adjusted to better reflect the economic cost of supply. Wholesale In 1998 reform efforts will be extended out- and industrial prices need to fall, and prices to ward from the center, and pilots will be ex- households to rise. Efficiency improvements (in panded to more regions. The four target areas dispatch and operating practices) should help of the 1998 program are increasing cash col- to bring down wholesale and industrial prices, lections, improving dispatch of generators to as will rebalancing when household tariffs are lower average fuel costs, boosting operating increased. Improved access to investment financ- efficiency, and reducing pricing distortions. ing is another potential source of tariff reduc- tions. Because of limited access to capital Viewpoint is an open forum intended to The government views financial viability of the markets, electricity tariffs currently incorporate encourage dissemina- sector, particularly increased liquidity, as key to full self-financing of new investments. But with tion of and debate on the success of the reform. While UES more than improved financial viability, UES and the Energos ideas, innovations, and best practices for ex- tripled its cash collections in 1997, further im- should be able to attract debt financing for at panding the private provements can be achieved only by resolving least part of the investment program. That would sector. The views pub- the nonpayment problem at the customer inter- allow prices to fall and would subject proposed lished are those of the authors and should not face, that is, at the Energo level. Initial efforts in investments to the discipline of review by the be attributed to the 1998 will be mainly diagnostic, though arrange- financial community. World Bank or any of ments have been made for the private sector to its affiliated organiza- tions. Nor do any of the run the commercial operations of one Energo Many problems remain to be resolved, and the conclusions represent under a management contract. Diagnostic efforts commitment to reform periodically loses steam official policy of the initially will focus on ten regions. Consultants as pressing political issues arise. But on bal- World Bank or of its Executive Directors will work with the Energos to identify the causes ance the Russian government has taken im- or the countries they of the nonpayments in each region and test solu- pressive steps toward creating a more efficient represent. tions. Actions to complement these initiatives will and effective electricity sector. To order additional include increasing the electricity traded for cash copies please call on the wholesale market and improving payment The World Bank has been a partner in the Russian electricity sector 202-458-1111 or contact discipline among budget-funded agencies. reform program for more than two years. It mobilized grant financing Suzanne Smith, editor, to help the government formulate the reform, provided technical as- Room F6P-188, sistance loans to support restructuring programs, and extended adjust- The World Bank, Improving dispatch could save an estimated ment loans to encourage sustained commitment to reform. 1818 H Street, NW, US$1 billion or more a year in fuel costs, and Washington, D.C. 20433, or Internet address initial steps to realize these benefits will take Margaret Wilson (, place in 1998. UES, the federal regulatory agency, Consultant, Europe and Central Asia Energy The series is also and consultants are developing an improved in- available on-line Sector Unit ( centive system, including dispatching guidelines html/fpd/notes/ and procedures. New guidelines are to be in notelist.html). place in at least one zone (of seven) by the end Printed on recycled of June. If the pilot efforts are successful, they paper. will be extended to other zones.