Social and political attitudes toward cheap power were a major obstacle to electricity liberalization in Poland; they also may be one in Russia.
The Feb. 1, 2003, edition of Public Utilities Fortnightly contained a pair of articles (Competition Lost, and Superpower Opportunities) about utilities that invested abroad during the 1990s. The pairing of the articles leads to the question of what can be learned from the past to facilitate investments in future opportunities.
The experience from Poland is especially applicable for the future of restructuring the power sector in Russia. Poland, the third largest Warsaw Pact country (after Russia and Ukraine), is the most advanced in the restructuring process, and it bears many structural similarities to the power sectors in both Russia and Ukraine. But Poland was quicker to undertake market economy reforms and, consequently, first to encounter problems. An understanding of those problems can guide investors to a better appreciation of some of the issues that will arise during the upcoming reforms in Russia.
The emerging democratic countries got caught up in the enthusiasm, the wave of power market liberalization, and the power plant development boom that started with the United Kingdom in the early 1990s. As early as 1993, Poland made ambitious commitments to The World Bank, and others, to privatize the power sector. Very early, Poland broke off power generation from transmission and distribution. The national transmission company (Polish Power Grid Co., or PSE) was a monopoly buyer of power from more than 50 individual power generating plants. Electricity was distributed by 33 local distribution companies, all of which had to buy their electricity from PSE. Everything still belonged to the state, however. In the subsequent restructuring, all companies in the power sector were converted from state-owned enterprises (a non-commercial legal structure) to enterprises formed according to the Commercial Code. These were either joint stock companies or limited liability companies. They were expected to function as self-supporting commercial enterprises with a profit motive. This is where the trouble began. The root of the problem was the tradition of Communist Socialism that electricity was cheap-and society expected it to remain cheap. In fact, people looked at the results of liberalization in the United Kingdom, saw that the prices had come down, and concluded the same would happen in Poland. They were watching the building boom in the United Kingdom with some envy. They knew they needed similar levels of investment. New to the world of capitalism, they were ready to try anything. Advisors from multilateral institutions, non-governmental organizations, and prestigious consultants urged them on. The free markets would, could, solve everything.
Benefit to No One?
The unfortunate reality was that restructuring of the power markets in Poland appeared not to benefit any of the various constituencies of the power sector: the consumers, the workers, the support industries, or the managements. Government, however, looked with a hungry eye at the potential revenues from privatizing power generation assets. Early results in places like Hungary indicated that there were a lot of bidders with very generous acquisition budgets and large appetites waiting eagerly to pick up power generation assets.
Despite the large potential revenues from privatization, progress was slow from the start. Social and political resistance pressed on the government from every direction. The reasons are very instructive as to what to expect in Russia as Unified Energy Systems (UES) tries to restructure itself in the coming two or three years.
Consumers were having a hard time keeping up with rising prices in Poland. Inflation in 1989 was more than 200 percent. By the mid-1990s it had dropped into the range of 30 percent or more per annum. Prices were generally set based on political considerations with little or no reference to economic costs. This was especially true of electricity, and remained true through much of the 1990s. Under the post-Communist governments of the early 1990s, electricity prices were set by the Finance Ministry, but the power plants were given overall management direction by the Ministry of Industry and Trade. Thus, the inflationary pressures were a process of coming to terms with what things really cost, and putting those costs where they properly belonged.
The result was that the consumer got badly squeezed. The Ministry of Finance fought hard to retain the rights to set those prices for social reasons. Government policy specifically dictated that electricity prices, at the consumer level, could only grow at a rate somewhat less than inflation.
All the while, the government was repeatedly announcing plans to change that. The power industry was slated to become open to "free market prices." An electricity trading floor was established, but little electricity traded. Invitations to bid on power plants were announced, and some transactions occurred, but many did not. The public was not happy. The perception was that any private buyer of power generation facilities would immediately seek to raise prices.
In short, social and political attitudes managed to block a number of privatizations and delay many others.
Under the Communist system, full employment was mandated. Anyone who wanted a job could have it. The power industry absorbed a lot of employees that were not needed. The workers knew that any buyer of a power facility in privatization would reduce staff in large numbers. The unions are very powerful in Poland, and they succeeded in distorting the process.
One of the requirements in any privatization bidding process was, at a point prior to final negotiations with the Treasury over purchase prices and terms, the necessity to negotiate "the social package" with the unions. Typically, the social package guaranteed no reduction in the labor force for a period of time, offers of severance pay for voluntary reductions, and a bonus to be paid to all workers on financial closing with the Ministry of the State Treasury upon privatization of the company. These packages tended to escalate in cost as the process went forward. No union wanted to settle for less than a previous one had.
Since the law was silent on the matter, and there was no recent history of protecting the rights of capital in Poland, it took the regulatory officials a few years to accept that capital costs needed to be included in tariff calculations. This dissuaded a number of potential foreign investors from participating in Polish tenders. But despite the problems, Poland is moving forward. Foreign investors were disappointed because their expectations were unrealistic. The Polish government also had expectations that were too high.
Restructuring of the energy sector is an unfinished work. Those that invested already (notably Électricité de France, Vattenfall, and Tractebel) have done reasonably well. The long-term indications for all three are for more, rather than less, involvement in the Polish energy sector.
Similar Problems for UES
UES is an enormous company: 155,000 MW of generating capacity, more than 70 percent of the entire Russian market, 2.5 million kilometers of transmission and distribution wires, and 245 subsidiary companies. Understanding such a sprawling enterprise is a mammoth challenge. Restructuring it cleverly, constructively, and successfully will be an even greater one.
As Poland restructured the monolithic power sector early on, so did Russia. In Poland, the separations were along lines of business: transmission, distribution, and generation became separate sectors. In the case of UES, the separations were geographic. Much of the generation and distribution assets were put into 72 different "energos" that became subsidiary companies of UES. UES itself retained some generation assets and the national transmission system. Some of the energos were sold off in part.
In April of this year, the Russian parliament (Duma) passed legislation to allow the restructuring of UES. The concept is to reorient the industry into generation companies and local distribution companies. No generating company will have more than a 35 percent share of any geographic market. UES envisions about 10 generating companies being set up that will then be put up either for sale or for management under contract.
For the Russians, management contracts avoid the stigma of selling the family silver to foreigners. For foreigners, the idea of putting large amounts of shareholder funds at risk anywhere right now is anathema. However, management contracts would allow companies with talent and expertise to generate shareholder benefits by leveraging that expertise in the Russian market.
Setting up the new generating companies will be contentious. The existing shareholders of the energos already have objected strenuously to what they view as asset stripping by UES. Still, signs indicate something will be worked out with the minority shareholders in the energos and that the new companies will be set up.
After that, the process of attracting investment into the power sectors will start. This will require actions on pricing and management control similar to those that ran into such difficulties in Poland. By understanding what those were in Poland, one can anticipate and manage them when they occur in Russia. In summary, the following lessons from Poland can be applied to the UES restructuring project:
- Price. Adjustments are going to be difficult. UES generating companies will be squeezed between social and political pressures to keep electricity prices down, while at the same time Gazprom will be pushing hard to raise prices for gas, which it has to do. Any plan to manage or acquire generating assets will need to include mechanisms to mitigate this risk;
- Worker resistance. In Poland, unions were strong and exerted an almost veto-like power over government actions. In Russia, the Communist Party is still a political factor and will likely exercise some of the same influences on government actions. The Communist Party may try to impose similar conditions on the privatization process as the "social packages" in Poland sought to impose;
- General political support for restructuring. The process is certain to require further enabling legislation from the Duma and support from the federal administration. That support cannot be taken for granted, and there will be setbacks. But because the process is too important to fail, it will not fail, and the necessary actions will occur, although the process may not be pretty at times;
- Regulatory inexperience. Private capital issues will be a problem in Russia as they were in Poland. The only fix to this problem is working with the regulatory agencies to make sure that they are made aware of the valid concerns and requirements for private equity participation, whether that equity is Russian or foreign.
Finally, advance preparation is essential. All too often in Poland, potential investors lost out because they misjudged the timelines. Politically difficult actions tend to get postponed before they take place. When the difficulties get resolved, it happens quickly. Investors should not be misled by the postponements to think that there is plenty of time to prepare. Once decisions are made to proceed, the actions will take place quickly to avoid anyone changing their mind and blocking the actions. It is easy to get left behind.
The restructuring of UES is likely to create one of the largest opportunities the world has seen for participation in restructuring of an electricity system. It would be a shame to miss the boat.
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