Olga Bodrova

As the Russian government initiates a new scheme of liquidating cross subsidizing, one of the most acute problems in the electric power sector, through the introduction of norms for power consumption and regional government subsidies, analysts welcomed the move, believing that "last mile" contracts could be abolished without a sharp tariff growth for residential consumers. However, they noted that the move could have a negative impact on distribution grid companies, specifically Siberia IDGC and Urals IDGC, which are the most dependent on cross subsidizing.

The Energy Ministry has proposed discontinuing so-called “last mile” contracts, a mechanism of cross subsidizing in the power industry, in the 18 regions that are mostly affected by the problem, business media reported recently.

During the reorganization of former power monopoly UES, the Federal Grid Company of Unified Energy Systems (FGC UES) received the country’s trunk grids with a tension of at least 110 kilovolts, while interregional distribution grid companies (IDGCs), part of IDGC Holding, received distribution grids of lower tensions. Large power consumers connect their facilities to trunk grids, thus becoming clients of FGC UES. IDGCs only have small companies and residential consumers as clients, who are not able to provide the companies with sufficient revenue. Under “last mile” contracts, FGC UES leases out some power transmission lines to IDGCs, so that industrial consumers pay for power transmission to both FGC UES and IDGCs, whose tariffs are higher than those of FGC UES.

“Last mile” contracts were initially expected to be in force until 2011, as the government sought to change the tariff calculation system in the sector within three years of UES’ liquidation in 2008. However, as no changes were made, the government issued a bill in 2010 to prolong “last mile” contracts until 2014. In late 2011, former Energy Minister Sergei Shmatko proposed postponing the liquidation of "last mile" contracts until 2017.

Cross subsidizing became especially problematic in the past several years. The combined value of "last mile" contracts has been estimated at 58 billion rubles in 2012, Deputy Energy Minister Mikhail Kurbatov said at a meeting of the government commission on the fuel and energy complex, adding that the total volume of cross subsidizing in the power industry would reach 207 billion rubles this year.

The contracts are first to be abolished in the Altai, Primorsky, Krasnoyarsk, Perm, Chita, Sverdlovsk, Chelyabinsk, Lipetsk, Rostov, Tyumen, Kirov, Tula, and Amur regions, as well the constituent republics of Buryatia, Mari El, Komi Republic, and the Jewish Autonomous District, as listed by Kommersant business daily.

The method for liquidating cross subsidizing in these regions is expected to be defined by September 1. The current order will not be abruptly abolished, as tariffs for the general population could soar by at least 15%, one of the commission’s participants said. Two others said that tariffs were to gradually grow to the national average. Moreover, a social norm for consumption will be introduced and those consumers who exceed this norm will have to make an additional payment.

In addition, part of residential consumers’ expenditures are to be compensated by regional governments, the efficiency of the grid complex will be increased, while the investment programs of grid companies can be reduced, an official at the Energy Ministry said.

Analysts welcomed the government's intention to solve the problem of cross subsidizing in the power sector and believe that "last mile" contracts could be abolished without a sharp tariff growth for residential consumers, but noted that the move could have a negative impact on distribution grid companies' financial results.

"We are happy with the government's initiative concerning the long-standing problem of cross subsidizing and “last mile” consumers, which has a negative impact on the investment attractiveness of the power sector," Alfa-Bank utilities analysts said. They noted, however, that they had yet to see certain measures taken by the government and their implementation before making conclusions on how the move will affect the sector.

Utilities analysts at VTB Capital also welcomed the government's initiative, saying the introduction of a social quota was likely to help eliminate some of the existing imbalances in the utilities sector and the cross subsidies between industrial and household tariffs. "The measure would help decrease the electricity bill for industrials, which is one of the government's targets, in our view, although the impact on the profitability of distribution companies is likely to be neutral to negative, as it might be combined with additional pressure on distribution tariffs," they said.

"I believe that the proposed measures will lead to the improvement of the situation without any abrupt tariff growth in the majority of the troubled regions," investment company Metropol senior utilities analyst Konstantin Reyli said. The analyst, however, stressed that everything will depend on the regional governments' readiness to provide subsidies and on the degree of the "last mile" significance for grid companies. "I think that with coordinated actions and all the measures that have been mentioned, solving the problem of the "last mile" is quite realistic in the majority of the troubled regions by 2014," the analyst concluded.

Despite the expected positive effect, analysts pointed out that the government's move could have a negative impact on distribution grid companies.

"Plans to abolish the "last mile" create additional risks for distribution companies. The introduction of a social norm and the provision of regional subsidies, in our view, do not fully compensate for the decrease of revenue, which means that the abolishment of the "last mile" within the given scheme will be financed to a large extent with IDGCs' incomes," UralSib Capital analysts said. The analysts believe that the abolishment of the "last mile" will negatively affect results of the most troubled IDGCs, including Urals IDGC and Siberia IDGC.

"The abolishment of the "last mile" as a one-off event could lead to either significant financial losses for IDGCs or an abrupt growth of tariffs to compensate for those losses," Reyli from Metropol said, expecting that Siberia IDGC would be affected the most by the move. The analyst also said that the problem of "last mile" was especially significant for Siberia IDGC, as well as for Urals IDGC, Center and Volga IDGC, and Center IDGC. "Least of all, the problem is present at South IDGC, MOESK, and Lenenergo," he said.

Investcafe analyst Konstantin Marchenko also believes that Urals IDGC and Siberia IDGC are in the most difficult financial situation, as these companies were receiving the majority of their revenue from consumers who are now switching to direct deals with FGC UES and cancelling deals with IDGCs. Many of these consumers initiate claims against grid companies trying to return the money they paid earlier, while IDGCs are seeking compensation from regional governments, Marchenko said.

Analysts also said earlier that many large power consumers were now willing to build their own power production facilities as they are unhappy with the fact that they have to make excessive payments for power because of the “last mile”. If cross subsidizing is not abolished, the number of such consumers will grow, which will lower IDGCs’ revenues, analysts warned earlier.

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