28-10-2004
The Russian Investment Review

The General Director of ZAO “Integrated energy systems” Mikhail Slobodin replies to questions about Russian Energy reform and his company’s role in this process.

1. What is the aim of energy reform in Russia?

One of the largest scale reforms that are continuing in the Russian power industry will restructure the current power monopoly and create competitive wholesale and regional power companies. The restructuring of the power industry is the most complex and effective reform of the natural monopolies, which the Russian government has undertaken. Today the number four power industry in the world (which is smaller only than the USA, Japan and China) is experiencing a period of unprecedented transformation.

The traditional objective of any reform is to improve the existing system.The restructuring of the Russian energy sector is targeted towards the attraction of investments and building a more effective structure in the sector. In addition, a transfer to effective mechanisms of market price is planned will be realised through the reform.

The current system of electricity rates based upon the ‘costs plus’ principle doesn’t motivate the electric power producers to reduce their production costs. The transition towards the market pricing mechanism gives producers completely different signals and directs them towards cost reduction.

• Could you describe how and why the different views of the restructuring vary?

Energy reform affects the interests of a large number of groups. Each of them has its own vision of the situation, its losses and its dividends from the restructuring. Therefore there is a certain variety of opinions and approaches.

First of all there is the point of view of large consumers. At the moment they are acquiring a considerable quantity of electric power at low prices. Any rise in costs will create enormous system risks for them. For example, 30 % of expenses in the aluminium industry come from electric power. Thus as a result of fast and thoughtless steps in the reform, one can get good prices for electric power (for electric power producers), but lose the most important consumers. A way out of this contradiction can be found by the correct structuring of relationships between consumers and power producers.

Another group of interests is represented by RAO “UES of Russia” itself, and its managerial team that wants to realise a large project. They have developed the principles of their business development and are trying to realise the reform in this framework.

The third group of interests is the private companies that consider the Russian power industry as their strategic business. There are just a few such companies in Russia, but they have already planned and initiated long term investments in the power industry and they are accumulating highly valuable experience in power company management under the conditions of a developing market. ‘Integrated Energy Systems’— a company that was founded at the same time as the beginning of Russian power industry reform — is one of the most illustrative examples.

Strategic investors in the power industry are becoming a centre for attraction and concentration of capital, special knowledge and technology and highly qualified senior management personnel.I suppose that this group is the most interested in the successful accomplishment of the scheduled reforms in the power industry and it consistently upholds the strategic interests of the industry itself. After all, if the accepted reforms in the industry are realised, in near future these companies will become one of the main players on the power energy market.

There is also the point of view of the state. First of all, the government has to solve the main problem of the industry. That is the attraction of private investments for the sake of the modernization of the infrastructure and equipment, and of building a more effective power energy structure that is one of the bases for the future dynamic development of the Russian economy.

Theoretically, they can try to achieve it without changing the industry structure and price formation, i.e. by delaying the reform process as this always creates risks especially during the first three — four years. However, in that case, the energy industry could become a serious limiting factor for economic development of the country and for the improvement of the population’s living conditions.

The Russian government understands all these risks and dangers of the reforming process. Perhaps, that explains the fact why the government is acting so carefully and cautiously at the initial stage of the power industry restructuring.

• Some critics argue that the selling of the electrical system at the present time will be bad for Russia. How do you answer this criticism?

Well, first, privatisation will not happen all at once, it is a planned process. Companies with different forms of property will be present on the market for a long time from the moment the reform starts. So we can’t talk about any “sales”.

I’d also like to remind that such private power companies as “Irkutskenergo” and “Novosibirskenergo” have existed for a long time in the Russian energy industry. By the way a new power block has been recently launched in “Novosibirskenergo”. There aren’t any special problems with the independence of these power companies. The only area where in my opinion we should focus our attention is the issue of optimal structuring of the market and correct configuration of power companies which are being created in the process of the reform. But this problem is dealt with by the anti-monopoly legislation.

The apprehensions of the “reform critics” are groundless because electric power supply manual supervision remains in the hands of the government. “The System Operator” is a subsidiary structure of RAO “UES of Russia” today and in the future it will become a state company. One may ask if private companies will follow the regulator’s directions. But this is rather a problem of regulations and the right structure of the relationships between the market stakeholders. These regulations should include financial and administrative sanctions for those who do not carry out the regulator’s requirements.

• ‘Integrated Energy Systems’ holding is a leading private Russian energy company. There are major state Russian energy companies, for example ‘GAZPROM’ competing in the forthcoming sale of power assets. Why do you believe you can compete?

Many want to ‘play’ energy, but few really do anything. To buy a share holding in the regional power system or in RAO “UES of Russia” itself is the simplest thing. It doesn’t mean yet that the new owners are actually going to do anything with the power business. In reality, it should be followed by a large number of actions targeted towards raising company efficiency. It is necessary to determine the best ways of cost optimization and the key directions for business restructuring, to show the reasons for company inefficiency etc. You should by any means solve the question of management, define the priorities in the investment project realisation field, and choose the correct market behaviour tactics.

From the point of view of participation in the electrical power business ‘GASPROM’ is no different from the most of the portfolio investors. It is evident that the power industry is still an unprofitable part of the company’s activities in comparison to the main business of ‘GASPROM’.

For ‘Integrated Energy Systems’ energy is the strategic line of the company’s development. Our team has been specially selected to effectively manage a power business, to meet serious energy challenges in the interests of clients in the industrial sector and housing sphere.

This is perhaps our competitive advantage.

Nowadays, investors regard our coming into any regional power company as a considerable positive factor, and the market reacts to it. For example, the regional power companies’ shares after “Integrated Energy Systems” had finished the process of controlling shareholding consolidation (“Komienergo”, “Nizhnovenergo”, Permenergo”, “Rostovenergo”, “Sverdlovenergo” ), outperformed the power companies’ share market growth in general by 15-16 %.

• Do you see the future of the energy sector in Russia as a healthy mixture of private and state energy companies?

Conceptually we will anyway be in a situation with of private and state energy companies in the power industry. Nuclear power and most of all the hydro-power engineering are state owned. But I can’t see any problems with that.

The only problem which may occur is a certain discrimination against private companies. Government will have all the regulation: first of all the System Operator and then the Unified National Power Grid Operator that manages the networks. This can give a real advantage to state generating companies. And any discrimination leads to a risk increase for independent electric energy producers. However, if the regulations of the market are clear and transparent then private power companies will have no difficulties. In principal, foreign experience shows that such a combination is possible.

• Central to your strategy is a provision of integrated power solutions for consumers such as large industrial companies, and in the retail market. It is said that SUAL-Holding (which is also a part of ‘Renova’ Group businesses) is the largest customer of ZAO ‘Integrated Energy Systems’. Do you ever envisage this changing?

I would like to destroy the myth that ‘Integrated Energy Systems’ is a kind of energy ‘appendage’ of ‘SUAL holding’. There was no need to create such a powerful and diversified energy company that nowadays carries on business in almost all segments of power industry just to serve the interests of ‘SUAL’.

Created in December 2002 and being established in parallel to energy reform, by the summer of 2004 ZAO ‘Integrated Energy Systems’ felt the necessity to structure clearly its energy business in order to increase its efficiency.

Apart from the managing company ‘KES — Management’, there are three independent business structures within ‘KES — Holding’: ‘KES — Multi Utility’ (business in the field of housing and communal services), “KES — EnergoStroyEngineering’ (building of high voltage transformer substations and power transmission lines) and ‘KES — Energy Solutions’ (complex energy consulting).

As is well known, apart from this, ‘Integrated Energy Systems’ owns and manages a shareholding in RAO ‘UES of Russia’, OAO ‘Russian Utilities Systems’ (RKS) and a blocking shareholding in five regional energy companies (“Komienergo”, “Nizhnovenergo”, Permenergo”, “Rostovenergo”, “Sverdlovenergo”).

‘Integrated Energy Systems’ develops business projects of great potential in the other sectors of the power industry. The company has a clear and independent strategy of development that is fully connected with the perspectives of the Russian energy industry.

Certainly we broadly use the experience and technologies that have been tested on the consumers of ‘SUAL — Holding’ in our interactions with other big industrial structures. To an extent the circle of big consumers is one of the main strategic tasks for ‘KES — Energy Solutions’.And I would like to say some words about the other important businesses of ‘KES — Holding’. For example, ‘KES — Multi Utility’ is now serving more than 700 thousand consumers (households) in the retail market of energy, heat and gas supplies in Perm and Sverdlovsk regions. The energy supply for consumers in the housing and communal sector in 2004 will be 4 billion kilowatt-hours and more than 10 billion cubic metres of gas.

Comprising four big net construction companies in Siberia, ‘KES — EnergoStroyEngineering’ provides almost 10% of the total volume of the federal market of high-voltage lines’ and transformer substations design and construction and more than 70% of the market of the Urals and Siberia.

And now a few words about the business that ‘KES — Holding’ considers to be the key one — generation. The total installed capacity of the five regional energy companies, the strategic shareholding of which belongs to ‘Integrated Energy Systems’, is 6.5 thousand megawatt, the energy payload supply is more than 78 billion kilowatt-hours, the number of consumers is more than 10% of all the Russian consumers of energy.

The strategic aim of ‘Integrated Energy Systems’ is to get control of a number of regional generating companies (TGK) in the regions where the company operates. One of the main projects of ‘KES-Holding’ in this area is the participation in the creation of a regional generating company in the Urals (TGK #9) through OAO ‘Permenergo’ and OAO ‘Sverdlovenergo’. Moreover, ‘KES – Holding’ aims to participate in the privatization of the wholesale generating companies (OGK), which are being created in accordance with the programme of RAO ‘UES of Russia’ reform.

‘KES –Holding’s’ participation in the privatization of the Russian power industry is aimed at the creation of a big generating company. It is proposed to accomplish energy asset consolidation by 2007-2008 and to form one of the leading energy companies operating effective business in all the segments of the Russian energy industry — in generation, distribution, delivery, selling, services and energy construction.

• How do you judge the future of investments in the field and the private companies’ roles in the Russian power industry?

It’s evident that in the coming decade the major part of the Russian power industry assets with sales volume of several dozens of billions of dollars a year will change their owners.In a few years effective electric power companies will be established in Russia including those combining generation, distribution and sale. It is clear that the key role in “building” of such companies will belong to strategic investors — private companies that even today are ready for long-term investments into the electric energy business.

I’m sure that strategic investors, focused on the creation of new energy companies with maximum effectiveness and capitalisation, are actually becoming the locomotive of Russian energy reform today.

All this allows us to judge strategic investments into the creation and development of new energy companies as very attractive for Russian and foreign investors.