Graham Stack in Berlin -

UES announced on Tuesday, October 23 the swap ratios for consolidating Russia's 80-odd "energo" regional distribution companies into 11 Interregional Distribution Companies - which wags have dubbed the "DisCos" - sending their share prices rocketing. Has a new electricity reform party started?

As the privatisation of Russia's power monopoly United Energy Systems (UES) moves into its last nine months, most of the attention has been focused on the ongoing sales of the wholesale generating companies (known as OGKs in Russian) and the territorial generating companies (TGKs). However, there is another piece of the power business that is coming under the gavel: these DisCos.

Many of these companies have already been listed. And while investors have not ignored these stocks, they haven't seen the appreciation that the OGK and TGK stocks have enjoyed, probably because until they are consolidated they are too small for most investors. However, as UES revs up to flog off the DisCos, the spotlight is finally swinging their way; as with the OGKs and TGKs, the first step is to repackage the DisCos into bigger bundles, hence the importance of swap rates.

"Yes, it's a great investment story," says Trust Investment Bank's Dmitry Sergeev. "Only today, after the announcement of the share-swap, Vologda Energo stocks rose by 10% and in Ryazan Energo by 15% on the MICEX. We see upsides for Ryazan Energo and Nizhny Novogorod Energo of 50%, and of 45% for Vologda Energo and Pskov Energo."

The formation of the new consolidated distribution companies, Russian acronym MRSKs, marks the next stage of the UES restructuring and it has got off to a great start.

"Consolidation is definitely a primary value driver," explains Sergeev, who published a report on the MRSKs for Trust Investment Bank. "At the present time, the distribution companies are too small for foreign investors. Consolidation will lead to stock liquidity increasing. A drop in liquidity risks makes it interesting for foreign portfolio investors to take positions."

Analysts also agree that operating efficiency should increase through improved economies of scale, as happened with the consolidation of Russia's regional fixed-line telecommunication companies.

Analysts were divided over the valuations produced by the UES Evaluation Committee. Evaluations of the discos to be folded into the Siberian MRSK were under market prices, but relative values are much more important than market prices. "We think that relative values are much more important than market prices, as UES tends to undervalue companies in official valuations to prevent the risk of shareholders seeking buyout offers during reorganization and we view DisCos as attractive overall," says Aton Capital in a note.

Moreover, removing uncertainty about the swap ratios should lift the stock. "We believe that the swap ratio approval may trigger investor interest in the company due to elimination of unfair appraisal risks," reckons Sergeev.

The only way is up, baby

The Russian electricity sector has nowhere to go but up. The entire UES reform process is being driven by alarming growth rates in demand for electricity, which threatens the system with collapse after a decade of underinvestment. Analysts say electricity consumption is rising 4-5% per year and by as much as 6-8% in regions such as Moscow, North-West and Siberia.

Just as with the generating assets, DisCos will need large-scale capital expenditure just to keep up with demand, meaning IPOs and private placements are on the cards. "At least two power distributors are likely to conduct an IPO within one or two years after consolidation in the first half of 2008. As MRSK-Holding, which is to spin off from UES in 2008, is expected to own at least 50% of each MRSK, the most likely IPO candidates are Tyumen MRSK and MRSK Volga, in which MRSK-Holding has stakes of 100% and 60%, respectively," reckons Trust Investment Bank.

Despite the initial requirement for 50% state ownership to be retained in the consolidated DisCos after UES is broken up next year, Sergeev believes this is only for the short term. "We think the MRSKs will be privatised within two or three years."

The other value driver is the expected shift to Regulatory Asset Base (RAB), which is the international regulatory standard for power distributors, and means that distribution tariffs are set by the regulator to provide the DisCos with a fair return on their invested capital. "If a company increases investment for modernisation this will be reflected in a higher tariff," explains Sergeev. "This draws on foreign experience, and moves away from the current primitive regulation based on cost and profit."

Basically, this boils down to a price hike for electricity distribution services. But when? This is where politics plays a role. RAB was originally scheduled for 2008, but was recently postponed.

"It is a new practice for the government and not easy to introduce for whole country," explains Sergeev. "Consolidation of MRSKs will be completed in summer of 2008, and RAB introduced, in our opinion, by 2009. Postponement of RAB regulation by more than two years may undermine investor interest in Russian power distributors," he adds, but on the other hand, "extensive capex needs of distribution companies make RAB regulation indispensable."

The hike in end-user electricity prices is estimated at around 15% relative to the 2007 prices, which should be absorbable given rapid economic growth. However, the recent surge in inflation might make the government cautious about regulatory price rises - and there will be no UES around any more to bully the government into taking bold steps.

But uncertainty about when wholesale price liberalization will take place hasn't stopped investors from buying into Russian generation assets. And now following the release of the swap ratios this week, it looks like the DisCos will be packed also.

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