Tim Gosling in Moscow -
The election cycle has thrown up deep uncertainty over Russia's utilities sector, but investors and analysts argue that it's no more than a temporary blip, and the prospects for the sector after March 2012 are bright.
Election years provoke populist policy around the world. In Russia inflation is nearly always top of the list and so Prime Minister Vladimir Putin's call for a 15% price cap on electricity tariffs in February inevitably hit investor sentiment on the sector. In the debate that followed, officials suggested tariff growth in 2012 could be capped as low as 5%, sending shares in the sector sliding further. In January, the RTS utilities index sat at its highest since July 2008; by May, it was at its lowest in 16 months.
However, although a final decision is not due until the middle of July, it appears that investors have begun to recollect that the government has kept all of its promises to the private investors that came into the sector over the past 10 years. Comments from officials have hinted at a softer stance, suggesting the government will stand by promises made during the privatisation of UES in 2008. The break-up of the state's rump electricity holding saw investors commit to build 36 gigawatts (GW) of new capacity whilst the government essentially promised to ensure returns.
Whilst the RTS index saw its traditional early summer sell off in June, utilities began to climb out of their hole. The revival accompanied improving inflation figures, as the growth of food prices slowed in June and allowed record lows in Russia's CPI. The Ministry of Economy promptly suggested tariffs should be allowed to swell by as much as 11%. "The market has over reacted to the government comments," insists Liam Halligan, chief economist at Prosperity Capital Management (PCM), a large minority shareholder in several generation companies (gencos). "The government has said that revenues foregone due to any limit of power tariffs would be shifted to future years, rather than lost completely. In addition, as the election season ends in early 2012, the negative rhetoric will subside."
Derek Weaving at Renaissance Capital points out that while officials have complained publicly that consumers simply can't afford higher electricity prices, this is clearly not the case. As he illustrates, Russian household electricity prices are the lowest in Europe, accounting for no more than 1% of household expenditures.
The majority of analysts support the idea that strict tariff caps are no more than playing to the gallery, and retain a bullish view on the sector given healthy demand forecasts. As Mikhail Rasstrigin at VTB Capital suggests: "The market is likely to start pricing in the possibility of there being a positive resolution to the tariff debate. Hence, risk takers might start buying at current depressed levels."
Halligan says PCM has been buying through the dip. "The medium- and long-term potential of the sector is huge and the latest pre-election rhetoric has made valuations even more attractive," he says.
The crux of the issue for analysts and investors alike is that the government has little choice but to let tariffs off their leash once the elections for the Duma and presidency are past in March. The sector kicked off the privatisation and liberalisation processes a decade ago because Russia desperately needed investment into new generating capacity. Nothing has changed today.
According to the International Energy Agency, the sector has "huge investment needs," pitching the figure at $380bn from 2003 to 2030, with the bulk of this investment needed after 2010. "The federal government has no choice but to revert to its previous policy of competition- based reform and price liberalisation," states Weaving.
Over and above anything else, the need for investment will see tariffs cut loose sooner rather than later. "The building of power sector capacity is absolutely crucial to Russia's future growth," says Halligan. "The government is well aware that building such capacity requires private sector capital and that investment will only happen if the private owners of Russia's gencos are able to make decent returns."
"The deal," he continues, "has always been that if private investors build new capacity, then the government would allow them to make returns. They've always kept those promises throughout the last 10 years - and I don't see them stopping now."
Not just policy
Meanwhile, commentators suggest that whiles sector sentiment is overwhelmingly driven by government policy right now, the fundamentals currently being overlooked look strong.
For one thing, the growth of fuel costs appears to be slowing dramatically for some. Rasstrigin points out OGK 4 (with fuel accounting for 72.5% of costs) entered into a five-year fuel supply contract in 2010 offering flat year-on-year fuel price growth for 2011 (versus an industry average of up to 15%). Halligan points out that, "ministers said that gas tariffs may not be allowed to rise by much more than electricity prices. This obviously helps gas-powered generation companies."
Clearly, in the current policy environment, such cost management is vital across the industry, especially given the high cost of capital in Russia, huge volumes of which are needed to build the new capacity. Alexander Kotikov of Troika Dialog notes that OGK 4 is expected to increase its total installed capacity by 13% by the end of the summer, and Weaving says that management at many generating companies appear unconcerned by the prospect of long term tariff caps.
Overall, according to VTB, the Ministry of Economy forecasts electricity production will grow by up to 2.7% in 2011, 2.0% in 2012 and 2.2% in 2013, with $125.6bn to be invested in the sector, including 26.15 GW new capacity, in the same period.
At the same time, major consumers such as industrial companies are worried about price rises in the medium term, points out Rasstrigin. Minister of Energy Sergey Shmatko has talked of the need to create the economic stimulus needed to prevent them leaving the dilapidated national grid.
It's the inefficiencies in distribution pushing up prices most, according to analysts, and Rasstrigin says that he expects this scenario to prompt reform that will "finalise market liberalisation and enhance competition." Such concerns are also likely behind the disparaging comments from the anti-monopoly commission that met the announcement of a tie up between the utilities arms of Gazprom and Renova in early July.
But it's not "only" the sector's key role in economic growth that makes its path so important. Power utilities are also a pioneer, and therefore a signpost, for Russia's investment climate as a whole. One that should carry more weight than a jailed oligarch.
The 10-year reform programme through which the generating segment has passed is almost finished. It is one of the major industry transformations in the country, which saw it switch to a free market, embark on widescale privatisation, and provoke advanced regulatory practice and economic stimuli to efficiency. However, deregulation only happened in January, and hit the election rhetoric almost immediately.
Halligan agrees that's another factor that should see the government keep its promises to investors. With a new $50bn privatisation programme taking its first steps, and the search for foreign investment to upgrade the rest of the country's infrastructure cranking into serious gear via tools such as the new Russian Direct Investment Fund , "experienced investors would be aghast should the government renege on its commitments," he claims.
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