Ben Aris in Moscow -

It's back to the drawing board for Russia's utilities reform.

The Russian government admitted at the end of September that its reforms designed to set the regulated tariff rates have been driving badly needed investors away from the sector.

The Russian privatisation of the power sector at the end of the 1990s is one of the great unsung success stories of Russian reform and one of the biggest sell-offs in history. Foreign and domestic investors flocked to the sector, driving utility share prices through the roof. At the same time, a wholesale market for electricity sales was successfully set up, putting the generation business on a market basis.

However, the state has bungled the second phase of the reforms that sets up a mechanism to set regulated tariffs and distribution charges. Due to be launched at the start of last year, President Vladimir Putin put the tariff hikes on ice after it became clear the new formulae would send tariffs up by over a quarter only months ahead of the presidential election. Since then, the reform has been in disarray as industry players wrangle over how to fix the system to bring tariff increases down to a more acceptable levels.

Overhaul

At the end of September, Deputy Prime Minister Arkady Dvorkovich announced the government was in effect abandoning all the previous work and would overhaul the whole system, because "the current market model does not [fully] allow the attraction of private investment into electricity generation and grids." The new regulations will be ready sometime in 2014, Dvorkovich said.

The retreat is unusual for the government. This is the first time a finished plan has been thrown out wholesale after it was clear the plan wouldn't work, and is perhaps the mark of the new younger, more liberal cabinet that was installed in May.

Getting the power sector reform right is crucial for Russia's long- term prospects, as the country needs to attract billions of dollars into building new capacity, modernising existing power plants and upgrading its leaky grid.

The issues are complicated, but underlying the reform is the simple task of untangling the Soviet-era system of cross-subsidies, which are used to keep power cheap for the population by charging companies extra. For example, large companies connected directly to the main power grid still pay distribution charges, but removing these excess payments would plunge many of Russia's distribution companies into bankruptcy.

Dvorkovich says the government plans to tackle the wider electricity cross-subsidy issue, by defining it in the law, then quantifying it and adopting a roadmap to gradually abolishing it. "This is the first time a senior government official has recognized the cross-subsidy issue and the suggested solution, in our view, if implemented, would lead to economically rational pricing for the services of the electricity companies," Vladimir Sklyar, a utilities analyst at Renaissance Capital, says.

At the same time, the key rate-of-return (known as RAB in Russian) regulation is to be scrapped and redrafted by 2014. The RAB rules were supposed to shift the calculations for tariffs away from the previous cost-plus formula and give benefits to power companies that had invested in upgrading facilities. However, the government and utilities have been very unhappy with the rules, which have no provision for economically rational returns and were been revised twice in the last year alone. "The current state of affairs is something of a micro-managed halfway house, with liberalised wholesale electricity prices but fully regulated capacity payments, a competitive but state-dominated generation market and long-term regulation of the grid sector, with tariffs adjusted on an annual basis," says Sklyar.

Russian Energy Minister Alexander Novak said that the sector will need RUB11.4 trillion ($362bn) of capital expenditure through to 2020, and the key challenge the sector faces is where to find the money, because, "current sector regulation does not motivate companies to invest."

Still, the old concerns remain: Russian Prime Minister Dmitry Medvedev said at the same meeting where the roadmap was presented that Russia cannot afford electricity prices to grow at the same pace that it has over the last five years and new sources of money have to be found.