THE FAR EAST:

the power of energy growth

Attracting investors to the region of Far East is contingent on the development of power industry infrastructure. At present, this industry toils in the conditions of an undeveloped market, with deficient machinery and outmoded electrical grids. By 2025 “RusHydro” and “RAO ES Vostok” plan to put into operation about 4GWtt of new capacity from power stations, primarily to substitute the outmoded ones.

And this is just the start.

The project is created with support of “RusHydro” company.

Tariff mechanisms

A fight for every ruble

“RusHydro” suggests long-term tariff regulation instead of annual tariff review system
Magadan lights
© RAO ES of the East

Despite the non-market conditions that exist in the Far East region, “RAO ES of the East” and “RusHydro”  have found opportunities for attracting investment into their projects. As Sergey Tolstoguzov, “RAO ES of the East” CEO believes, “such difficult conditions stimulate out-of-the-box thinking, searching for alternative solutions and literally a fight for every ruble”.

“RusHydro” realizes that introducing market relations to the Far East can not “come out of the blue”, given the difficult conditions within this area. Thus, no such tasks were ever presented to the energy sector experts in this region. However, it is obvious that this is the pathway to follow, although cautiously, in the future. The total amount of necessary investment into the development of the Far East energy industry until 2025 is estimated at 630 bln rubles by the RAO ES of the East. “A free market of power capacity in the Far East, as exemplified in other regions of Russia, is deemed impossible, since we are the monopolists here. However, it would be beneficial to apply certain market methods in our area, as we are not able to achieve these construction sites by commercial credits only – the state would have to subsidize up to 40 bln rubles in additional funds annually,  to cover the heating power sector alone! – said Sergey Tolstoguzov in his interview to the “Kommersant” newspaper. – The energy sector of the Far East requires “longterm money” under low interest. It would be a mistake to think that we want to put all the burden of this colossal problem on the state and thus avoid providing funds for development of the region. We are interested in the economic efficacy of all future projects, even if this would necessitate longer terms of investment return, than those seen in the European part of the country. However, this would require changing the very logic of pricing in the Far East”.

We call for a transit to a long-term tariff regulation system, if not to a market analogue — Evgenij Dod, “RysHydro” CEO

At present, tariffs for heat supply in the Far East are reviewed annually. The Ministry of the Energy Industry seems to understand the case and suggests drafting a schedule of gradual increase of tariffs with a stable and reasonable indexation for a 5-year period. “This seems good, but in order to have an opportunity to invest safely into these projects  we need to understand how the tariff would change during the whole period of the investment return - which ,means at least 20 years in our given conditions,” – explains Sergey Tolstoguzov. Only under these conditions would our operators have a predictable money inflow, and investors would have an apprehensible and easily predictable revenue rate.

New model of tariff regulation

Other improvement suggestions include introducing a system of long-term power supply agreements in the Far East, - a system that has proven its efficacy in other regions of Russia. In such a system a new operator signs a treaty with the power customer with the price, capital costs and fixed revenue fixed. It would be good to also implement a system of direct agreements with major customers based on a “take or pay” principle. Moreover, RAO ES of the East suggests long-term fuel pricing and mechanisms of tax stimulation of energy sector projects and transition to RAB-regulation in network infrastructure.

The majority of these measures require amendments to  current legislation. Thus, the enhancement of the mechanism of direct long-term bilateral agreements with customers (including those under take-or-pay principles) in the non-pricing zone and isolated energy systems at the moment is hindered by the federal law “On Energy Industry” (although the amendments have been drafted already), as well as the introduction of targeted surcharge for the capacity  of HPS  that work in the market price zones (and the capacities of which are selected for KOM). “RusHydro” has suggested transferring these funds only for the construction of power-generating facilities that are included in the investment program of the Holding, including those in the Far East (importantly, this decision would have not affected pricing in non-price zones). At the same time, the creation of a long-term model of tariff regulation that considers return of the investment capital in the power industry of the Far East is undermined by the political will of the federal authorities. 

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State funding

With budget aid

The President of Russia has ordered 50 bln rubles of state budget to be targeted at financing “RusHydro” construction of 4 thermal power stations in the Far East
“RusHydro” Board Chairman Yevgenij Dod and the President of the Russian Federation Vladimir Putin (from left to right) during a visit to the ongoing construction of Nijhne-Burejskaya HPS
© ITAR-TASS/ Alexey Druzhinin

In conditions of total tariff regulation - which lead to a complete lack of investment in the Far East region - direct budgetary financing becomes crucial.  Both in Soviet and post-Soviet era the energy sector of economy remained gravely underfinanced. Despite the fact that under a planned economy framework all stations and transmission lines were still being built, the structure of this economy proved largely ineffective and costly under market conditions.

Such conditions would allow RAO ES of the East to deal only with the ongoing issues: prolonging power capacities of generators and conducting regular maintenance of transmission lines and transformers. All this could rest only on a hope that long winters would pass without any major emergencies. “We need to acknowledge that we are fully extended in terms of independent full-scale development of major generating facilities.” Unlike other regions of Russia that have market conditions of power energy pricing, “RAO ES of the East” works under conditions of total state control. The power tariffs are set by regional energy commissions. And, as a result, this tariff is set below economically feasible levels almost everywhere across the region. Of course, we get state subsidies, but they only cover some basic repairs. Thus, there could be no talk about any kind of stable revenue, not to mention any large-scale development investment”, -  the Holding's CEO, MrSergey Tolstoguzov, said in his interview to “Gazeta.ru” (by the end of 2014 the amount of state subsidies exceeded 12 bln rubles).

The President of Russia has ordered 50 bln rubles of state budget to be targeted at financing “RusHydro” construction of 4 thermal power stations in the Far East, - a decision that has become a turning point for this macro-region. “Our four construction sites in Yakutsk, Blagoveschensk, Sovetskaya Gavan and Sakhalin are the first large-scale projects in 30 years that utilize state funding in the energy sector of economy in the Far East region, - stressed Yevgenij Dod in his interview to “Kommersant” newspaper. – this construction is of great importance for the whole country, as we are in fact implementing the program ordered by the President. The construction of a new power facilities and the decommissioning  of existing outdated  power generating facilities will  create a positive money inflow for the reconstruction of power-generating facilities in the Far East, as a result of savings on fuel, amortization costs and etc.”.  Launching of all four facilities will  increase the power generating facilities of the Far East by 553 MWtt and 875.2 GKal/hour.

“A breath of fresh air”

The order of the President of the Russian Federation for the additional capitalization of “RusHydro” was issued in 2012. The funds were earmarked for the construction of four  heating power-generating facilites  – the first stage of the Yakutskaya State District Power Station-2, the second stage of Blagoveschenskaya TPS, the first stage of Sakhalinskaya SDPS-2 and a new TPS in Sovetskaya Gavan. These projects should have been launched long ago. For instance, the currently functioning Sakhalinskaya TPS became  outdated long ago and has already outlived its normal working life – a new station should fully replace it (however, it is not unlikely that the “old” TPS would not be shut down fully). The expansion of Blagoveschensk TPS’ facilities would allow local builders to “breathe fully”: at the moment, some of the already-constructed micro neighbourhoods do not have any heating, as there are no reserves. The thermal power station in Sovetskaya Gavan should replace the capacities of the outdated Mayskaya SDPS which is supplied with naval heavy fuel oil. SDPS-2 in Yakutsk will provide for the  growing heat and power demands of the central energy district of Yakutia and Yakutsk. Moreover, it will make it possible to shut down part of less effective and environmentallydamaging boilers. “These four stations are a “breath of fresh air” that the energy systems of these regions need right now – which amounts for a power capacity of more than 500 MWtt. It is the only chance to prevent a collapse of the energy system of the Far East”, - stresses Tolstoguzov. New stations are scheduled to be launched before 2017.

It is noteworthy that in 2012, when the decision of subsidizing 50 bln rubles from federal funds was made, there was no ready project documentation to support the blueprints of new stations. There were no landmarks, no tender-based general contractors, nor machinery producers. On completion of all projects’ development plans and after all necessary endorsements the estimated cost of four priority projects in the Far East accounted for 87.792 bln rubles. It is easy to conclude  that state funds are the main funding source for these projects. As explained by the state holding’ experts, these funds are channeled for acquisition of basic equipment and payments on contractors’ obligations in the most vital stages of construction and assembling works.  According to the company’s data as for July 2015, a total payment of 43 bln rubles from state funds was transferred to customer-developers, - this amounts to 86% of the state budget investment. Obviously, no major construction would have been started in the Far East without such investment. Although, the company is able to cover any additional costs with its own investment funds and other sources. “We initially understood and have continuously  reiterated the fact that the cost of construction of these four stations will exceed the volume of the earmarked state funds, as new construction projects are costly”, - stress experts of the company.

Money under control

© RusHydro, RAO ES of the EAST
© RusHydro, RAO ES of the EAST

However, it is not the fact of state channeling 50 bln rubles to finance these projects, but the system of control over the expenditure of these funds that is unique. Each project has undergone a difficult process of checks and endorsements, which include state-run expertise  and an independent audit of its project documentation, as well as additional discussion of the projects and the results of independent audit at the platform of the Scientific and Technical Council. As a result of these checks on each of the submitted projects a balanced review of technical and economic characteristics was endorsed. This resulted in federal authorities giving approval to the final costs. All procedures are presented in a quadripartite agreement on state budget investment into construction of energy industry facilities in the Far East, signed by the Ministry of Economy of the Russian Federation, Ministry of the Energy Industry, Sberbank and “RusHydro” in December 2012. All construction projects are also regularly checked by the Russian Court of Accounts. “This kind of a unique system of control is being used in Russia for the first time. Although it may seem vague, I am convinced that in the future it will be applied to all projects that require state funds, which will  make the process of state financing more manageable and transparent”, - tells Yevgenij Dod. Interestingly, despite all difficulties with endorsements, as stressed by “RusHydro”, the readiness of all four stations under construction in the Far East accounts to seven to 70%, including all manufactured and supplied machinery. All construction projects follow their schedules and shall be launched in time.

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Financial institutes

Bailing out of the debt burden

In July 2015, “RusHydro” signed an agreement with VTB bank, since the latter plans to participate in additional emission of stocks of the company in 85 bln rubles of value
© TASS/Mikhail Djhaparidze

As for July 1st, 2015, the total debt on loans and credits taken by the “RAO ES of the East” counted for 87.92 bln rubles. The major part of these are the “legacy” of “RAO ES Russia” enterprises. However, since 2008 this sum has almost doubled, due to the   need to finance the investment campaign in conditions of the unprofitability of the primary activity  of the company  - brought about by the current system of tariff regulation in the Far East.

There are several ways of resolving the debt problem suggested by the RAO ES of the East. One of them, for example, suggests acquiring subsidies to compensate part of credit interest payment expenditures or a transit of resource providing companies to a system of direct payments with customers (in order to resolve the issue of debit debts, which is also very high, accounting for about 23 bln rubles). It is essential to find mechanisms for both tax regulation of energy sector projects and compensation of lost incomes of RAO ES of the East.

While these ideas were discussed, bank VTB announced its participation in lifting the debt burden of RAO ES of the East. In July 2015,  “RusHydro” signed a preliminary term sheet agreement that envisages the possibility of the bank’s participation in an additional share release  from the Holding of up to 85 bln rubles,  with a simultaneous forward contracting for a 5-year period. Funds thus collected  are scheduled to refinance the debt of RAO ES of the East. While this agreement is yet to be endorsed, it has become known that VTB would be able to acquire up to 20% of the share capital of “RusHydro” and during the period of the forward contract it would be able to sell this package to a strategic investor. Otherwise, in 5 years’ time one of the parties to this agreement is to pay the margin between the sale price and the present value of the sum of investment. “RusHydro” is to transfer these funds to its far-eastern subsidiary by means of additional stock emission, as it seems.

Towards energy security

The company’s agreement with VTB is also unique. Although the fact of ongoing negotiations of “RusHydro” with the banks was known long ago, it was Sberbank that was announced as a prime bank contractor, and not VTB. The company sources explain the choice of the VTB as offering better conditions  in terms of credits. Moreover, unlike the case with previous emissions, including those of other state-owned energy companies (i.e., “Rosseti”), the agreement between “RusHydro” and VTB is a commercial one and does not require additional funds from the state budget (except for the state guarantees that with high probability would not be claimed). Finally, this agreement motivates the company’ management to enhance its work in terms of increasing the company’s value, as otherwise the company would have to pay the marginal costs. Such approach would influence the level of dividends, which in its turn would have an impact on investors.

However, the focus is put to the fact that refinancing of RAO’s debt would have a multiplicative economic effect for the energy sector of the whole Far East region. Today the debt burden hinders both tariff regulation and development programs of the holding. Lost dividends exeed 5 bln rubles per year because of credit interest payments. By decreasing its debt burden the holding will be able to focus on modernization of equipment as a result of emergence of new funds, which will lead to the increase of system safety of the energy sector objects. Also, in its turn, this would reduce the current costs of repairs. As a result, the energy security of the Far East shall be enhanced overall. 

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International cooperation

“RusHydro” and “The Three Gorges”

Companies plan to create a joint company to assist in construction and further exploitation of Nizhne-Burejskaya HPS
The construction of Nizhne-Burejskaya HPS
© RusHydro

The scale of changes of the Far East Energy Sector that are currently underway and those ahead, depends on the resolution of issues of financing new construction sites. Top managers of the “RusHydro” group turn to the APR countries for assistance, with special interest in cooperation with China. This is the framework of reviewing any large-scale cooperation of “RusHydro” with Chinese corporation China Three Gorges Corporation and Power China company.

In the first case, the talk is all about an opportunity of creating a joint company for finalizing the construction and further exploitation of Nizhne-Burejskaya HPS. A corresponding agreement between “RusHydro” and “China Three Gorges Corporation” has already been signed and the sides have resolved  to conclude a complex technical, economic and legal check of the project of the station currently under construction. This work will result in a complex evaluation of the economic efficacy of creating a joint company. “RusHydro” has already announced that “the parties to this agreement have already endorsed their approaches towards evaluation of the cost of the project with consideration of the past investment and the present value of the future money inflows”. It is worth noting that if such a joint company is created, it shall be a unique one. However, the Boguchansky project is a different case, as “RusHydro” has contracted Russian, and not foreign, companies to take part in it. As he commented on the issue of the agreement, Yevgenij Dod, “RusHydro” CEO noted that the agreement that was signed with the China Three Gorges Corporation is an important step towards a systematic work on widening the cooperation with Chinese partners and attracting Chinese investment into Russian economy. In future, the Nizhne-Burejskaya HPS will become a benchmark model for the implementation of anti-floodin WPS construction projects.

Such joint companies suggest joint investment, project set up, construction and exploitation of energy sector objects in Russia. Joint companies that fit such schemes can be set up in the nearest future in cooperation with Power China (for the construction of a small-scale HPS, primarily in the Northern Caucasus, as well as hydro-accumulating stations). Foreign investors are expected primarily in terms of capital export alongside with the export of technology and equipment.

“As for technologies and technical solutions, among other things, we look forward to exploring opportunities that are offered by the countries of the APR”, - says “RAO ES of the East” CEO Sergey Tolstoguzov. According to Mr Tolstoguzov, the main efforts are to be undertaken in two major directions. The first one deals with the technological equipment and maintenance of new projects in the traditional energy sectors. The second one deals with the renewable energy sources. We shall focus on these further.

 New energy-efficient technologies                                            

The issues of power generation equipment supply are now being discussed with the Chinese company Dongfang Electric Corporation. The agreement between joint stock company “ES of the East” and Dongfang was signed on May 20, 2014 during the state visit of the President of the Russian Federation Vladimir Putin to Schanghai. The companies have agreed on further cooperation in the sphere of repairs, technical renovation and reconstruction of current objects of power generation and the power grids, as the Chinese partners can offer new energy-efficient technologies to support this cooperation. The equipment offered by  Dongfang can be used in the process of construction of facilities at the Vladivostok HPS-2. It is important that Dongfang will provide assistance in conducting negotiations between RAO ES of the East and the Chinese banks in terms of acquiring the necessary investment. Sergey Tolstoguzov believes that Asian partners also have excellent competencies in the energy facilities’ repairs branch.

The APR companies strive to get to our market of renewable energy sources, as the Far East presents a invaluable experience in challenging their capacities under extreme conditions — Sergey Tolstoguzov, CEO of “RAO ES of the East”

The Japanese company Komaihaltek has provided “RAO ES of the East” with three wind power facilities with total power capacity of 900 kWTT free of charge (2 in “cold” state and 1 in “arctic” state) to be used in an isolated settlement of Ust-Kamchatsk of Kamchatka region – only to analyze the data recorded by these machines on the state of machinery’s functioning under giver natural and climate conditions. The first wind power facility was launched in January 2015, with two others under construction at the moment.

Another direction of cooperation suggests the implementation of projects based on application of co-generational technologies. Currently “RusHydro” and “RAO ES of the East” in cooperation with the Japanese companies Kawasaki and Sojitz Corporation are analyzing the possibility of constructing such power stations of average and low capacity in the Far East region, and elsewhere in Russia. Project management on such construction projects is currently underway in the port cities of Artyom and Vladivostok. The Japanese company Sojitz acts in the capacity of a financial partner is these projects, although project set-up and the evaluation of costs of these projects is currently not finalized. 

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The project is created with support of “RusHydro” company.