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Acceding to Succeed

How joining the EU may transform the Central and Eastern European electricity sectors
Fortnightly Magazine - July 2004

also will provide significant opportunities for investment. Distribution losses in accession countries continue to be higher than the Western European average and can be stemmed only by investments in capital equipment. New wires can help to decrease technical losses while metering equipment helps the distributor to better track and monitor consumption, thereby reducing commercial losses. In addition, automatic control equipment and software is required to decrease operational costs.

Electricity transmission also will require additional investment, as countries expand and enhance their transmission networks. As the internal market grows, the region will need new interconnections between different markets. In addition, investment opportunities are emerging in software and services to support nascent marketplaces and exchanges.

Challenges Faced by Private Investors

At the same time, there are numerous hurdles-both region-wide and country-specific-that investors will face in this region. Clearly understanding and addressing these obstacles are key to successful investments in the region.

Numerous obstacles to investment are seen consistently across the region. A major concern is that the market structures in most of these countries are still evolving, which could affect the cash flows of purchased assets. This is particularly true for generation assets. In a liberalized electricity sector, wholesale energy is compensated by a market price that is determined by the intersection of supply and demand. However, in the accession countries, predicting wholesale energy prices for the next five years, let alone the next 10 to 20 years, which an IPP project would require, is extremely complex.

Even when spot markets exist, they are highly illiquid, and there are few futures transactions except for the long-term contracts that were signed by the state in an earlier era. Market fundamentals, such as the shutdown of old, inefficient plant, can be uncertain for many years. Finally, the role of incumbent generators and their market power is a subject that is rarely addressed in the region, and yet is one that can have a large impact on strategic bidding scenarios when a wholesale market does evolve. The issue of market evolution also affects distribution and transmission assets, as the methodologies that determine tariffs for such services contain variables that are periodically changed, such as the allowed cost of capital, the regulated asset base (in particular following significant investments), and the efficiency target (X factor) in performance-based ratemaking regimes.

Another major concern is the challenge that investors face in accurately valuing companies or assets prior to an acquisition. Valuations are complicated in the accession countries due to the immaturity of financial and energy markets, local accounting practices, and concern about regulatory risk. The immaturity of financial markets complicates the determination of an appropriate cost of capital, while new energy markets usually are not reliable as long-term price indicators. At the same time, historic accounting of companies or plants (often distorted during years of state planning) is dubious at best, further complicating the analytical process. Finally, given the ongoing changes in market structure and regulatory framework, determining long-term cash flows with any certainty becomes a major challenge. That said, the ongoing accession process and the obligation for accession countries