Ben Aris in Moscow -

Russia's last big privatisation project begins as OGK-5 becomes the first power plant to go on sale. If this process to raise almost $80bn to build new capacity goes badly, economic growth could stall; if it goes well, it could be a bonanza for foreign investors.

UES CEO Anatoly Chubais has been on five road-shows in as many months to sell the idea of floating the country's newly created generation companies (gencos or OGKs) and distribution companies (discos or TGKs) to foreign investors.

He received pledges of over $1bn before he'd even packed his suitcase. Europe's biggest utilities companies are all sniffing out possible deals, tempted by a rare chance to buy up pieces of the industrial country's power sector. But there is still a long way to go before it becomes clear if this sell-off will be a success.

Time is pressing for Russia's government. At the start of this year a blackout in Moscow plunged the city into darkness just as temperatures plummeted below -30° Celsius, killing more than 70 people.

Chubais' warnings of an impending energy crisis have been becoming increasingly shrill as demand for power nationwide is poised to outstrip capacity. UES is already laying contingency plans for this winter in anticipation of more power shortages. Just under half of Russia's Soviet-built power stations have already exceeded their useful working life spans and the grid is already overloaded in the most populous regions.

Yet the Moscow blackout spurred the government into action, which approved a four-year, $79bn investment programme in July that will quintuple annual investment.

The IPO of the first genco, OGK-5, ended on Tuesday, October 31 and is a crucial test to see if private investors are prepared to cough up the money needed to finance the sector's makeover.

Chubais was quoted by newswires as saying the share price for OGK-5's IPO was set at $0.09 per share - closer to the top end of the price range declared earlier at $0.076-0.095 per share, thereby raising $459m. Chubais claimed the demand was several times oversubscribed, with strategic investors receiving some 5% of the 14.4% capital placed.

UES says Russia needs an additional 21.3 gigawatts (GW) of capacity by 2010, most of it paid for by private investors who are being offered shares in these newly created gencos.

"The situation is very acute not only in one, two or three regions, but in tens of regions," Chubais told President Vladimir Putin at a recent meeting. "For us, this means tough work under the threat of accidents and blackouts."

UES says it needs to invest at least $5bn a year just to stand still in terms of matching rising demand, but has only been able to scrape together at most $1bn a year. Under the new investment programme, UES will spend RUR462bn ($17.3bn) over the next three years on new generating capacity with the state contributing only $1.6bn.

"The big question now is how to raise the money to prop up the new (generating) companies as the asset base is deteriorating. The power sector has had hardly any investment for at least a decade," says Dmitri Bulgakov, a utilities analyst with Deutsche UFG bank in Moscow.

Remaking the sector

Unlike the oil sector, the Kremlin realises it has to give up control of the power sector if it is to attract the tens of billions of dollars in investment Russia's aging utilities need.

"UES used to hold stakes in some 72 regional energos, which were vertically integrated companies that did everything from generate the power to distribute it," says Bulgakov. "The issue is how to introduce competition into this market – you need to separate the generation, transmission and distribution companies or else people will abuse the market."

After several false starts, work on remaking the sector began in earnest last year and has gone remarkably smoothly. The energos did everything from generating electricity to delivering it to apartment blocks – in effect a series of regional monopolies. The trick has been to restructure the power business to introduce some competition and so create a market.

Over the last year or so, the energos have been broken up into about 20 gencos and discos. The idea is that the customer base of these new companies will overlap and so introduce the missing element of competition.

The key feature of the reform is that the new gencos will issue new shares to investors to raise the money necessary to pay for building new generating plants. And unusually for the government, Chubais says the state is happy to see its stake in these gencos diluted to 25% in the process. Even this "blocking" stake can be sold to strategic investors further down the road, with the state retaining strategic control by keeping hold of the distribution grid.

Another four of these gencos are going under the gavel in the following months. And in October, the UES board approved a second wave of 10 companies, which will issue shares in 2007-2008.

The consolidation of OGK-5's assets was completed in April this year after four power stations were merged to form one company. It is already producing financials under international accounting standards.

"The consolidation process varies from company to company," says Bulgakov. "In some cases it has been very complicated as some assets were never made into separate legal entities and so had no financials. These assets had to be incorporated and valued before the consolidation could even begin."

However, both domestic and foreign investors are starting to get excited by the prospect of theses sales and are already lining up to bid. Russian industrial holding Interros, owned by the tycoon Vladimir Potanin, already bought 5% of OGK-5.

Interros is going head to head with Enel, which has also expressed an interested in buying OGK-5. The Italian company has been aggressively expanding in Central and Eastern Europe, and has big plans for Russia but will face competition from the other major European power companies.

"In terms of big plays, Russia is the final frontier," Enel CEO Fulvio Conti said in September.

Given Russia's "wild east" reputation and the blatant bias in previous auctions, UES has bent over backwards to avoid the same mistakes this time round. Independent consultant Deloitte & Touche was brought in to value the assets before going ahead with the swaps and mergers that created the gencos.

UES also made sure the accounting firm's methodology was widely published so bank analysts could pick over the details and make sure nothing fishy was going on. And UES hired several investment banks to give a "fairness opinion" on the swap ratios.

IPO and divestment

Given many of the new gencos, such as OGK-5, are already quoted on Russia's stock exchange, the sales of their shares will not strictly count as IPOs. The listing is a result of their consolidation: some of the assets that went into creating them were already listed, so the consolidation of these public companies' shares with the new gencos amount to a backdoor floatation.

The sell-off of the gencos and discos is a two-stage process: first the genco will issue shares, which will be sold to raise investment money for the genco, then a "divestment" that will compensate UES' own shareholders for the loss of value caused by UES' decision to dilute its own stake in the genco.

OGK-5, for example, is 87% owned by UES with another 13% belonging to minority shareholders. The minority shareholders used to hold 50% of the Konokorskaya power station, which was one of four power stations that went into forming OGK-5 and their shares were swapped for those in the new larger power generating company.

OGK-5 will issue 5.1bn new shares, or about 14% of the total number of shares. The existing minority shareholders have the pre-emptive right to buy some of the new issue, but UES has already said it will not and so will see its stake diluted to 75% plus one share. The new shares will then be sold to portfolio investors – in effect forming the company's IPO.

The next step is the divestment. UES will be left with its 75% and will take 50% and use this to give each UES shareholder shares in OGK-5 in proportion to their shareholding in UES.

The ratio works out to about to be about 0.4 OGK-5 share for each UES share. This will leave UES with a 25%-plus-one stake in OGK-5, which it will eventually sell – probably to a strategic investor in about two years' time.

The difference between these two processes is that the IPO raises cash – the market value of 12% of OGK-5's stock – whereas the second process partly takes UES out of the picture but raises no money, while compensating UES shareholders for the loss of an asset that was once owned by UES.

That's the plan; but the sale of OGK-5 will be an acid test, as the mechanism for selling off all the gencos and discos is not set in stone. For example, at the start of October the UES board approved an additional share issue for TGK-3 (Mosenergo) in favour of a strategic investor, in this case Gazprom.

"The maximum size of the additional issue is set at 11.5bn shares, or 40.7% of Mosenergo's existing equity. The placement price for the new issue will be set at the weighted average of the market share price for the six months preceding the date of the company's EGM regarding the share issue, but cannot be set below RUR5.0 ($0.19) per share. The funds obtained from the share issue will be used to finance the company's capital expenditure needs," Alfa Bank said in a note.

"According to our estimates, after purchasing the new issue, Gazprom will increase its stake in Mosenergo to 50.2% from its current 30%, while UES' stake will be diluted to 36.2% from 50.9%. We see Mosenergo avoiding problems with gas supplies for its gas-fired power plants as the one positive outcome of Gazprom becoming its controlling shareholder," the bank said.

Chubais has also dithered over the question of whether the gencos will only be sold on domestic stock exchanges or can also be floated abroad. The first IPO is as much about testing the water as raising money.

"UES has suggested it will reduce its stake to 25%, but there is no rule: the placements will depend on market conditions as well as the interest of potential investors, both portfolio and strategic. It is these things that will determine the size and manner of the sales," says Bulgakov.

Wholesale market

Of course, few will be interested in buying these companies unless there is a market into which to sell power. The Kremlin put this last piece of the puzzle into place on September 1 when it started to increase the amount of power that utilities can sell on the nascent deregulated electricity exchange.

Currently power tariffs are set by a government committee and the state has been holding increases down as part of the effort to control inflation, but this has stifled investment. A trial wholesale market was set up six years ago and utilities were allowed to sell a small part of their output at prices set by the market. Prices have trebled since the launch, but Chubais hailed this month's decision to start raising the quota by up to 15% a year as a "new era" for the power sector.

"This is the kind of decision that moves the country forward," Chubais told a packed news conference.

However, analysts have said the change is too little too late, as it is still not clear just how long it will take for full price liberalisation. The official government plan states it will take anywhere between 5 and 15 years to completely free prices; Chubais was telling bankers in New York last month that prices would be completely free by 2009, according to reports.

Just in case the rise in power prices is very gradual, the government added a sweetener to make sure it gets the necessary investment: the Duma approved an investment guarantee mechanism that means if prices don't rise as expected, investors can claim compensation.

With demand outstripping new capacity growth for several years, consumers will also be protected from the inevitable "price spikes" by government subsidies for the first few years, says Chubais.

Investors have always been tempted by Russia's power sector, as the assets are amongst the few massively undervalued companies left. But they have been constantly frustrated by unfulfilled promises of reform. So far the government and UES have said all the right things, but investors are watching closely to see what they do.

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