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Investment summary
Key credit drivers of Russian utilities
Strengths/opportunities
Electricity consumption growth and capacity deficit
On the back of strong investment activity growth and a construction sector boom, we
expect electricity consumption to remain strong, and forecast a 2008-20 average
growth in the range of 3-4% pa. We believe that the relatively low consumption of
electricity by households at present could also support future demand. The prospects
for power-producing companies appear to be strengthened by an emerging capacity
deficit. In particular, relatively fast development over the past decade in the Moscow,
St Petersburg and Tyumen regions has pushed electricity consumption in the area
close to available capacities, with power plants already forced to limit energy supply
during peak loads. Both growing demand for power consumption and current capacity
deficits are expected to preserve the strong market environment for generating
companies over the mid term.
Strong competitive positions
One of the key strengths of electricity grid companies is their natural monopoly status,
with the high voltage transmission network, FSK, being of strategic importance for the
country. Although the government’s restructuring of the sector is an attempt to
enhance competition among the power producers, the lack of network capacity in
some areas continues to ensure low competition risk. The six OGK wholesale
companies have a relatively strong position in the electricity power market due to their
greater volume of installed electricity capacities, while the market positions of the 14
TGK regional companies are supported by dominant shares in local heat markets. The
market positions of the HydroOGK hydropower plants are strengthened by the cheaper
electricity that they produce, ensuring that hydrogeneration capacities are loaded into
the system first.
Involvement of strategic investors
The strategic control of the Russian generators OGK-4, OGK-5 and TGK-10 by
European utility companies should support their ability to manage operational and
investment risks, especially in the light of extensive capacity renovation and new
construction programmes. Access to external capital should enhance the financial
flexibility of local generators that fall under the control of European power companies.
For the generating companies OGK-2, OGK-6, TGK-1, TGK-3 and TGK-8 controlled by
the fuel suppliers, the key benefits include a more secure fuel supply and more
predictable fuel costs, as well as greater flexibility while making investment policy
decisions, as any such decision will always require agreement on future fuel supplies.
For companies that are to stay under state control, FSK, HydroOGK and FEGC, the
government’s financial support is viewed as a key strength.
Efficiency improvements
In our view, the potential for efficiency improvements by Russian power producers is
substantial given the extensive modernisation programme for generating capacities. In
line with regulator guidance, we expect the average fuel efficiency of thermal power
producers to rise 15% by 2020. In particular, the power sector investment programme
envisages the closure of inefficient and aged capacities of up to 50GW by 2020 along
with increasing investment in state-of-the-art technologies. Around 40GW of gas-fired
plants with less than 40% conversion efficiency are to be replaced by combined cycle
gas turbine (CCGT) plants with 55-60% conversion efficiency. The gradual upgrade of
electricity grids should support more efficient loading of power producers’ capacities.
For combined heat and power producers (CHPP), we expect additional improvements
in ‘waste’ heat utilisation, a trend which is likely to be driven both by capacity
modernisation and more efficient loading of electricity generating capacities. For
networks, the capacity upgrades are expected to reduce the electricity loss ratio. We
expect the share of electricity losses in distribution networks to fall from the current
8-9% to 5-6% by 2020 and from 3-4% to 2-3% in transmission networks. We also do
not rule out general improvements in the cost discipline of power sector companies,
especially those that have undergone privatisation or fall under the control of strategic
investors. On the whole, we expect efficiency improvements to contribute to widening
operating margins both for power producing companies and electricity grids.
Pricing change opportunities
Liberalisation of the electricity market offers opportunities for power producers as, on
the back of strong electricity consumption growth and supply shortages, the market
equilibrium price is prone to rapid growth. This is evidenced by electricity market prices
that have been twice as high as tariffs since mid-2007. However, in the medium term,
we believe the power market model will become a single-buyer market. Although this
market concept discriminates against cheap electricity producers (nuclear, hydro and
efficient thermal power plants), it should also significantly reduce business risks,
including much lower volatility in power prices. More importantly, a single-buyer market
should ensure minimal investment risk for generating companies, with payments for
new capacities sufficiently high to cover related investment costs. For electricity grids,
pricing change opportunities are associated with a shift to RAB regulation, which
should enable companies to recover the cost of investment in the network
infrastructure.
Weaknesses/threats
Aged capacities
The average age of power plants in Russia is slightly above 30 years, with the majority
having been commissioned 20-40 years ago. In addition, plants built in Soviet times
use currently obsolete technologies, being 20-60% less efficient than modern peers.
Life-extending investments into the grid will be essential to sustain electricity output, as
a third of Russia’s power network was constructed more than 30 years ago. This also
applies to the capacities and infrastructure of heat producers.
Regulation risks
We see a risk that the regulator will not tolerate large profits being made by power
companies, especially from uncompetitive or ‘unreasonably’ high pricing, with antitrust
and State audit bodies taking an active approach to power sector regulation. We also
see the risk that attempts to curb inflation may translate into caps on electricity prices,
to compensate for the lack of developed instruments that allow better control over
inflation. For example, FEGC is subject to discriminatory tariff regulations as the
government is capping electricity costs in the Far-Eastern area. We do not rule out the
possibility that HydroOGK will be subject to regulation that is less favourable compared
with thermal power plants, as the regulator attempts to contain electricity costs at the
expense of the relatively cheap electricity produced by hydro power plants. We also
see regulatory risks for heat producing companies as heat energy is expected to
remain under tariff regulation, which the government is free to cap once the risks to
inflation are recognised. For networks, the main regulatory risk is associated with
potential cancellation of connection charges, considered among the key capex funding
sources over the next few years. In particular, MOESK and Lenenergo are more
exposed to this risk.
Aggressive capex and leverage increase
Both for generating and network companies we expect negative free cash flows over
the next five years as a result of their aggressive capex plans. The investment plans of
HydroOGK, FSK and MOESK may preserve negative free cash flows for even longer.
We believe that FSK and MEOSK are among the networks that are most exposed to
leverage increase, with a debt/EBITDA ratio of 3-4x over the mid to long term. For
generating companies, we expect any leverage increase to be temporary and following
the active investment phase (2008-11), the increasing share of capex needs is
expected to be financed with operating cash flow. The only exception could be FEGC
that, due to tighter profitability, may not show much progress in deleveraging, with
debt/EBITDA likely to be above 3x over the mid term. Up to 2010, we believe that
OGK-5, TGK-1, TGK-4, OGK-6 and TGK-8 may show a leverage increase of above 2x
debt/EBITDA. For OGK-5 and TGK-1, leverage could potentially become even more
aggressive. The projected debt level increase stems primarily from their relatively
active capex programmes over the next two to three years and/or relatively smaller
equity financing volumes. We also identify upside risks to the projected leverage of
power companies related to growing inflation of capex budgets. In our view, the current
deficit of generation equipment and construction capacity on the back of significant
power sector demand creates a strong possibility of capex cost inflation.
Limited investment policy flexibility
Despite the fact that most investments in new thermal power plants will be made by
privately-owned companies, owners are expected to comply with the government’s
view on the sector’s capacity needs. In particular, commitment to the investment
programme must be secured by a special agreement with new controlling shareholders
of given companies and is an obligatory condition for investors. In addition, a
generating company will have to sign an agreement to ensure the supply of a certain
volume of capacity to the market according to the preset investment programme
schedule. Strategic shareholders that fail to meet the agreement are expected to be
fined.
Fuel supply/price risks
Fuel supply/cost risk is one of the most significant for thermal power plants, affecting
both the operational and investment activity of generators. This is evidenced by often
constrained access to fuel supplies for newly constructed power plants such as North-
Western TEC. At the same time, generators are significantly exposed to negative fuel
price shocks with limited ability to pass the costs on to consumers. For example,
during peak power demand (eg, winter 2005-06), generating companies sometimes
have to shift to more expensive reserve fuels, such as fuel oil, which can make power
production uneconomic under the preset tariffs. In particular, generators with a high
share of gas consumption may face higher fuel-related risks as gas supplies to the
local market are generally limited and gas prices are prone to more rapid price growth
over the mid term. The government plans to raise local gas prices in parity with the gas
export netback, which means the almost 80% discount in current local prices
compared with the world average level may significantly tighten within the next several
years. As a result the generators that are not exposed to fuel supply/price risks at all
(HydroOGK) or only partially (TGK-1) will be better placed. We also believe that fuel
related risk is much lower for generating companies that are integrated with fuel
suppliers (OGK-2, OGK-6, TGK-1, TGK-3, TGK-8).
Summary of trade ideas
On the back of the turmoil in the financial markets, we believe the bonds of Russian
utilities are among the most secure plays in the local market. This is additionally
ensured by rich SPO proceeds of power sector players. We identify some trading
opportunities within the sector.
Contents
Investment summary 2
Russia’s power industry: an emerging capacity deficit 7
Power sector reform 13
Power price deregulation 19
Price and margin trends 24
Capex and borrowing needs 36
Involvement of strategic investors 42
Outstanding debt 45
Companies 47
OGK-2 .....................................................................................................................48
OGK-5 .....................................................................................................................50
OGK-6 .....................................................................................................................52
HydroOGK...............................................................................................................54
TGK-1......................................................................................................................56
TGK-3 (Mosenergo) ................................................................................................58
TGK-4......................................................................................................................60
TGK-6......................................................................................................................62
TGK-8......................................................................................................................64
TGK-10....................................................................................................................66
FEGC (Far-East Generating Co).............................................................................68
FSK .........................................................................................................................70
MOESK ...................................................................................................................72
Lenenergo ...............................................................................................................74
Tyumenenergo ........................................................................................................76
Disclosures Appendix 78
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