Liberalisation of the Russian power sector

Energy Policy 31 (2003) 745–758

Liberalisation of the Russian power sector

David Kennedy*

European Bank for Reconstruction and Development, One Exchange Square, London EC2A 2JN, UK

Abstract

The paper discusses the Russian power sector reform plan, approved by the government in July 2001, which outlines the

framework for competition and changes in ownership structure. The paper focuses on the following issues related to the plan: price

reform; restructuring of regional energos and large generating companies; restructuring of transmission and system operation; the

mechanism for introducing competition; competition for residential consumers; and reform sequencing. One key message of the

paper is that price and regulatory reform is central to success of market liberalisation. A second key message is that the restructuring

of energos should not create companies with market power. Ideally, local generation and distribution companies would be owned

separately with multiple generators in each region. At a minimum, commonly owned companies should keep separate accounts, with

regulation of generation a possibility where there is market power. Regarding transmission and dispatch, common ownership would

not be a problem given that transmission and generation are separately owned. On competition, a fully fledged pool may not be

appropriate in the case of Russia, with the alternative of a market based on bilateral contracts with a balancing pool functioning

better in a context of non-payment and constrained institutional capacity, and providing security for investments. Regarding

competition for residential consumers, this is not a priority in the short to medium term. Lastly, on sequencing, it is better that

structural and institutional change takes place before competition begins.

r 2002 Elsevier Science Ltd. All rights reserved.

JEL: D40; L10; L33; L41; L51

Keywords: Power sector; Price reform; Ownership; Competition; Reform sequencing

1. Introduction

Reform of the power sector is one of the key policychallenges currently facing Russia. If the sector isnot reformed, it is likely that the present inefficientperformance will decline further due to lack of financeavailable for necessary investments. If reforms aresuccessfully implemented then finance should becomeavailable to support development of an efficientand high-quality power supply. After various stalledreform efforts, the government recently endorsed aplan for radical industry restructuring. In particular,the plan focuses on ownership restructuring, marketliberalisation and regulation; this paper focuses on theseareas.There is a growing body of theory and evidence

regarding power sector reform suggesting that privatisa-tion in a context of liberalisation and effective regula-

tion can bring efficiency gains that may benefitconsumers.1 The government-approved reform planfor the Russian power sector is consistent withobjectives to form a competitive and well-regulatedindustry. Principles in the plan remain broadly stated,however, and it is in the detail of implementation wheresuccess or failure of reforms lies. Going forward, themain issues that need to be addressed include the extentto which ownership of various industry assets remainsintegrated and the market model to be chosen.

*Tel.: +44-20-7338-7459; fax: +44-20-7338-6110.

E-mail address: [email protected] (D. Kennedy).

1For evidence on UK power sector reform, see Newbery and Pollitt

(1997). Elsewhere in the world, there were over 900 private

infrastructure projects worth US$300 billion of investment in Africa,

Latin America, Asia and the transition economies between 1985 and

1995. For more information, see the World Bank Private Infrastruc-

ture Database. For evidence on restructuring in transition economies,

a summary is provided in Commander et al. (1999). Evidence suggests

privatisation and liberalisation give the greatest impetus to industry

restructuring and productivity increase. Such reform helps to eradicate

corruption within the company and introduces new (commercial)

skills.

0301-4215/03/$ - see front matter r 2002 Elsevier Science Ltd. All rights reserved.

PII: S 0 3 0 1 - 4 2 1 5 ( 0 2 ) 0 0 1 2 5 - 8

One key message of the paper is that price andregulatory reform is central to the success of marketliberalisation. A second key message is that therestructuring of regionally integrated generation anddistribution companies should not create companieswith market power. Ideally, local generation anddistribution companies would be owned separately withmultiple generators in each region. At a minimum,commonly owned companies should keep separateaccounts. Regarding transmission and dispatch, com-mon ownership would not be a problem here given thattransmission and generation are separately owned. Oncompetition, a fully fledged pool2 may not be appro-priate in the case of Russia, with the alternative of amarket based on bilateral contracts functioning better ina context of non-payment, and providing security forinvestments. Regarding competition for residentialconsumers, this is not a priority in the short to mediumterm. Lastly, on sequencing, it is key that structural andinstitutional change takes place before competitioncommences.The paper is laid out as follows. Section 1 presents a

list of definitions of the various components that makeup a power sector. Section 2 describes the presentorganisation and performance of the Russian powersystem. Section 3 outlines some basics of power sectorreform. Section 4 summarises the reform plan. InSection 5, issues relating to market liberalisation underthe reform plan are discussed. These include: pricereform; ownership of generation and distributioncompanies; ownership of transmission and dispatch;the market mechanism; competition for residentialconsumers; and lastly, issues related to sequencing.

2. Definitions

Power generation is the conversion of primary energyto power (or heat). This can occur through a variety ofgeneration processes including thermal (coal, gas, oil),hydro and nuclear. In Combined Heat And PowerPlants, heat used in the process of power generation issupplied to local district heating networks for consump-tion by residential and industrial customers. Generationcapacity is measured in watts (or kilowatts (kW,1000W), megawatts (MW, 1000 kW), gigawatts (GW,1000MW)), and relates to the potential rate of energyproduction.

Transmission is the transportation of power over longdistances across high-voltage networks.

Distribution is the local transportation of poweracross low-voltage networks to the consumer.

Supply is the sale of power to consumers and involvesbilling and metering. The unit of supply is kilowatt-

hour, that is, the rate of energy consumption multipliedby the time over which consumption takes place.

Market operation comprises the forming of a meritorder—ranking of plants from least to most expensive—of generators in an idealised setting; i.e., one in whichthere are no system constraints that might in practiceprevent generators from operating. Market operationalso comprises organisation of financial settlement ofthe system, that is, payments from consumers togenerators.

System operation largely involves reconfiguring meritorder dispatch (ordering plant to supply the system),taking into account system constraints, particularlytransmission congestion. In real—rather than ideal—dispatch scenarios, high-cost generators near to demandcentres may be called upon when transmission capacityconstraints are binding.

Vertical integration refers to a situation wheregeneration and distribution are commonly owned,possibly together with other industry componentsabove. This could be within a monolithic structure, orwith different industry components keeping separate

accounts, or within a holding company structure. Thelatter two here characterise an industry which isvertically unbundled. The most extreme form ofunbundling is separate ownership.

3. Current industry structure and performance

The Russian power system comprises 210GW ofinstalled capacity,3 70% of which is thermal, 21% hydroand 9% nuclear, and 700,000 km of high- and low-voltage lines. The dominant player in the industry isRAO UES, a 52% state-owned company, with 30% ofshares foreign-owned and the remaining shares held byemployees, management and local investors. RAO ownsthe transmission network and dispatch facilities, to-gether with 22 large thermal power generators and fivehydroelectric generators. In addition, RAO ownsmajority stakes in 50 of the 70 regional integratedgeneration and distribution companies (‘‘energos’’) andhas minority (49%) stakes in all but three of theremainder.A wholesale power market—called the ‘‘FOREM’’

and organised by RAO—is in place in Russia. Thisshould function on the basis of a centralised merit orderdispatch, with the market operator taking bids fromgenerators to supply, ranking these from the least to themost expensive, and dispatching the cheapest plant tomeet demand. A fundamental problem is that RAOplays a dual role as market operator and marketparticipant, and thus has a vested interest to diverge

2Defined in Section 6.3.

3This is around 3.5 times the size of the system in England and

Wales.

D. Kennedy / Energy Policy 31 (2003) 745–758746

from merit order dispatch, selecting its own plants overcompeting plants even though this might not be theleast-cost option. In practice, dispatch has not beenaccording to merit order, with political and socialfactors influencing decisions, and with RAO unitsdispatched before lower-cost alternatives (e.g., energo-owned hydro plant). Though the central wholesalemarket may potentially be bypassed through bilateralcontracts between generators and large consumers, thesehave been undermined by difficulties in gaining access tothe RAO-owned network.4

By any standard definition, regulation of the powerindustry is not independent.5 There is no legal stipula-tion that tariffs should cover cost, and lobbying (e.g., bylarge industrial groups and government ministries) isimportant in tariff determination.6 Average tariffs forthe Russian power sector at 1.2 cents/kWh remain lowrelative to long-run costs, and cross subsidy remainsprevalent with an industrial/residential consumer priceratio of 1.8.7 These price distortions support ongoinghigh energy intensity relative to western Europe, withpower consumption of 3 kWh per $ GDP.8 Highintensity is explained both at the level of the endconsumer, where incentives to cut back on consumptionare limited, and in production, where there are onlyweak incentives to invest. Regarding investment, thereare clearly potential gains here, with thermal efficiencyin generation9 averaging 17.5% (compared with 40% inwestern Europe and 60% for plants based on moremodern technology10) and losses in distribution andtransmission equal to around 12% (relative to anaverage of around 5% in western Europe).11 In fact itis estimated by RAO that the Russian power system willrequire investment of US$15–30 billion over the next 10years if increasing system operation costs and decliningsystem security are to be prevented.

4. Basics of power sector liberlasation

Traditionally, the electricity supply industry in itsentirety was viewed as a naturally monopolistic indus-try. More recently, it has been recognised that scaleeconomies are limited to certain aspects of the business.A new principle for power sector organisation hasemerged, stating that competition should be introducedwhere possible. Natural monopoly functions should beseparated out from the rest of the industry andprivatised within a context of effective regulation.12

Power generation is not characterised by largeeconomies of scale, particularly as regards new technol-ogies (e.g., combined cycle gas turbine (CCGT)) and is apotentially competitive market segment. Transmissionand distribution are not candidates for competition,given that this would require wasteful duplication offixed costs. These parts of the business should beregulated to ensure that competing suppliers are grantedequal network access at a price that reflects underlyingcosts. They should be owned separately from generationin order to ensure that there is a level playing field forcompetition. This industry structure is represented inChart 1.Power sector reform was pioneered in England and

Wales where privatisation started in 1990. As part ofprivatisation, old area electricity boards were succeededby Regional Electricity Companies, each with a localmonopoly over electricity distribution. Competition forlarge user supply was phased in, starting in 1990 with the1MW and above market and extending to the 100 kWmarket from 1994, with full retail competition (i.e.,including for residential customers) from 1999. TheCentral Electricity Generating Board of England andWales was split into three generating companies, two ofwhich (National Power and PowerGen) were privatisedin 1991 and the third (Nuclear Electric) in 1996, and aseparate transmission company (the National Grid)privatised in 1995.13

Privatisation and liberalisation in England and Waleswere successful in bringing industry costs down, throughthe pressure that this put on coal prices, the introductionof new technologies, and labour restructuring. Ingeneration, cost reductions worth d2,300 million perannum were realised, while significant cost savings intransmission and distribution contributed to a realreduction of around 10% in the typical residential billand 7% real reduction in the typical industrial bill overthe first 6 years of privatisation.14

In Scotland reform started in 1991 when the oldvertically integrated utilities—North of Scotland Hydro

4See Opitz (2000) for a description of the functioning of the

wholesale and contracts markets.5For example, the regulator is not appointed for a fixed term, and is

funded by the government rather than through licence fees.6See Opitz (2000) for elaboration.7Price data are taken from the EBRD (2001).8At PPP exchange rates, this ratio falls to just under 1 kWh/$. This

may be compared with England and Wales, for which the ratio is

0.3 kWh per $ GDP. These figures are derived from IEA (2000) and

IEA (2001). Though England and Wales would be expected to have

higher consumption per capita than Russia, given the higher income in

the former and a substantial body of evidence to suggest that income

elasticity of demand is positive, the reverse is actually true (i.e.,

consumption per capita is slightly higher in Russia than in England

and Wales). Energy intensity in transition economies is discussed in

detail in EBRD (2001).9Thermal efficiency relates to the conversion of primary energy

(coal, oil, gas) into power.10Figures for thermal efficiency are taken from European Commis-

sion (2000).11Figures for losses are derived from IEA (2000).

12See e.g., Riechmann and Schulz (2000).13The National Grid was owned jointly by the regional distribution

companies from 1990 and floated in 1995.14These figures are taken from CRI (1997).

D. Kennedy / Energy Policy 31 (2003) 745–758 747

Electric Board, and South of Scotland Electric Board—were privatised as Scottish Hydro Electric and ScottishPower. Thus, this provides a contrast to the Englandand Wales model (because the privatised companieswere vertically integrated rather than separately owned).In terms of outcomes, where the English reforms yieldedsignificant gains, this was not the case in Scotland,where performance improvements were limited;15 thissuggests the benefits of full rather than partial unbund-ling.In the United States the most high-profile example of

power sector reform has been in California, with highwholesale prices, blackouts, and threatened financialviability of distribution companies following marketliberalisation. Whereas in England and Wales marketliberalisation was preceded by sector restructuring andprivatisation, this did not happen in California, wherethe three vertically integrated utilities were alreadyprivately owned. A wholesale market was set up inwhich these three companies would compete, and thisworked well for the first 2 years after liberalisation.Wholesale prices began to rise, however, in the secondhalf of 1999, and the year on year price increase at theend of 2000 was around 500%, with further increases in2001. In addition, there were supply interruptions, withblackouts costing the regional economy in the order ofseveral hundred million dollars.

Price increases occurred for a number of reasons:there was a significant increase in the gas price at thesame time as the power price increases; capacity waslimited due to a lack of entry, initially due to investorsconcerns over market risk (in the early 1990s before themarket was in place) and later due to delays in theawarding of permits to potential entrants. Higherwholesale prices were not passed through because of aregulation which provided a price ceiling at the end userlevel, and thus the financial viability of the utilities wasjeopardised (one of these filed for bancruptcy).16

The lesson from the California experience is not thatpower markets are necessarily flawed. Irrespective of theinstitutional setting when there is a supply shortage, andgiven the low elasticity of demand for power, then a highprice is required to clear demand and supply.17 If highprices had been passed through to consumers, thenutilities would have remained financially viable, andblackouts could have been avoided, at least to someextent. Moreover, if there had been no barriers to entry,then there would have been additional capacity avail-able, which would in turn have reduced the necessarylevel of price increases.18

Moving back in time, and following the positiveexperience in England Wales, provision for the liberal-isation of European markets was made under the ECElectricity Directive finalised in July 1996. This allowedvertical integration of power companies subject to theproviso that different industry components keep sepa-rate accounts. Phasing in of competition was required,starting with the largest users (annual consumption over100GWh), extending to 9GWh per year consumerswithin 6 years. By 2000, all member countries hadreached the 30% minimum target for large user marketliberalisation, with an average across the EC of 66%,and a 100% in the Scandinavian countries together withGermany and the United Kingdom. Evidence suggeststhat market liberalisation has resulted in price reduc-tions for large users averaging 25%, more so whereliberalisation has been deeper.19

In response to concerns over market power associatedwith vertical integration (elaborated in Section 6.2) theEC developed proposals to require legal and func-tional—rather than just accounting—separation of

Chart 1:Reformed electricity structure

Consumers

Competing generating companies

Regulated transmission company

Regulated distribution companies

Chart 1.

15See Newbery (2002).

16See Falk (2000) for a more detailed discussion.17See Kahn (2002) for calculations of peak prices required to clear

demand and supply; he suggests that these may be required to rise to

$12,000/MWh, relative to a long run marginal cost of around $50/

MWh.18Whether there are any lessons to draw on the role of market power

(integration of generation and distribution, and the small number of

companies in the market—is not clear: the evidence on whether the

utilities engaged in gaming is mixed, see Borenstein et al. (2000) and

Quan and Michaels (2001) for alternative views. For a discussion of

lessons for developing countries, see Besant Jones and Tenenbaum

(2001); these are reflected in the discussion in Sections 6.1 and 6.4.19See European Commission (2001) for more details.


different industry components.20 This was not, however,adopted at the Barcelona summit of member states inMarch 2002. The benefits of liberalisation were recog-nised at this summit, which resulted in agreement toliberalise all large user markets by 2004.In emerging markets, the earliest power sector

reformer was Chile, where industry unbundling beganin the early 1980s, with privatisation taking place at theend of the decade. There was competition for largeusers, who could engage in bilateral contracts withgenerators. In addition, there was a centralised arrange-ment—a quasi market—for supplying to consumersoutside the contract market. One lesson from the Chileexperience came in the late 1990s when a supplyshortage resulted in severe blackouts. Failure to stemthis problem either through price adjustments orimplementation of arrangements for rationing high-lighted weaknesses in regulatory governance.21 The factthat this weakness occurred in a country whereinstitutions are generally thought to be strong hasimplications for the appropriate liberalisation model inother emerging markets and transition economies; theseare discussed in Section 6.4. From a positive perspective,the reforms in Chile did lead to cost reductions, and thispositive experience spurred similar reforms in Argenti-na, Brazil, Bolivia, Columbia and Peru.22

In transition economies, power sector reform has beendriven by EU accession requirements and by the need toraise off-budget finance for investments. Bulgaria andRomania are in the process of unbundling theirindustries with a view to privatisation in 2003. Hungaryhas gone further, with unbundling and privatisation ofsome generation and distribution companies starting in1994.23 There has, however, been only limited liberal-isation in accession countries, with some large usercompetition in Hungary, Romania and Slovenia, theresults of which are as yet unclear.Further east there has been radical reform—unbund-

ling and privatisation/liberalisation—in Georgia, Ka-zakhstan, Moldova and Ukraine. As regardsliberalisation, events in Georgia and Ukraine haveshown the difficulty of operating a centralised marketwhen there are problems with payments discipline andgovernance. Neither of these markets work efficiently:the most efficient plant is not dispatched, paymentproblems continue, wholesale market payables farexceed receivables, there are very limited incentives for

new entry even though this is economically desirable;these issues are discussed in more detail in Section 6.4.In Kazakhstan, liberalisation of large user marketsbased on a decentralised (bilateral contracts) modelappears to be working reasonably well in difficultcircumstances.24

5. The reform plan

Following long discussions between various factionsin and around the industry, a reform plan for theRussian power sector was adopted by the government inJune 2001.25 The broad objectives underpinning the planare to separate out natural monopoly components of theindustry, identified as being transmission and dispatch,and to promote competition in generation and supply,with the transition to a new industry structure beingmade in a manner consistent with protecting rights ofminority shareholders. The intention is that thesereforms will attract finance for necessary sector invest-ments and that these will be implemented in an efficientmanner.Section 1 of the plan proposes development of a

wholesale market. It is envisaged that initially 5–15% ofthe market will be open to competition on the basis ofan auction. That is, generators will bid to supply thecompetitive market and large consumers (industrial,regional distribution companies) will bid to purchasefrom the market. Over time, and reflecting the phasedway that markets in western Europe have been liberal-ised, an increasing proportion of the market will becomecompetitive. Going forward, instruments for hedgingrisk (relating to dispatch and to price volatility) will bedeveloped, e.g., future markets may be developed.Further down the line, the plan is to introducecompetition for all retail consumers (so, e.g., residentialconsumers will choose between competing companiesfor supply of power). As with the wholesale market,there will be a stepped introduction of retail competi-tion, with energos having an initial monopoly oversupply, and multiple supply companies emerging overtime.Section 2 of the plan covers issues relating to industry

structure and ownership. Under the plan, all high-voltage lines will belong to one company which willinitially be formed as a subsidiary of RAO. Over time,RAO will revert to 100% state ownership and focus ontransmission, with private interests becoming concen-trated in generation companies and energos. A separate

20These are documented in European Commission (2001).21Fischer and Galetovic (2000) provide a detailed analysis of the

Chile reforms.22See Bacon and Besant Jones (2001) for a discussion. There has

been less progress in market liberalisation in Asia, where private

finance/participation has occurred under long-term off take contracts.

In Africa, there has been very little in terms of power sector reform.23See Kennedy and Stern (2001) for a discussion of power sector

reform in transition economy EU accession countries.

24See EBRD (2001) for elaboration. Also, Nosov (1999) provides a

detailed analysis of the reforms in Ukraine.25 ‘‘Basic Guidelines of the Governmental Policy on Reforming the

Power Sector of the Russian Federation’’, Government Resolution, 26

June 2001. An English translation of this document can be found at the

RAO UES website: www.rao-ees.elektra.ru.


http://www.rao-ees.elektra.ru

state-controlled system operator will be set up, and thenmerged with the transmission company after RAO hasdivested its generating assets. In addition, a separatemarket operator will be set up. Generation companieswill be created, the size of which will be limited by (to bedetermined) a capacity threshold designed to limitmarket power, and with the possibility that these maybe regulated depending on the depth of competition.Regarding energos, generation and distribution assetswill be subject to financial separation (e.g., throughaccounting separation or within a holding companystructure), and there will possibly be some consolidationwhere companies are currently too small to be of interestto private sector investors.Reforms are to be implemented in three stages and are

planned to take place over the next 10 years. The firstphase of stage 1 will last 18 months and will include thesetting up of a national grid subsidiary, a systemoperator, and a number of generating companies to beheld as RAO subsidiaries. Also during this phase, amarket operator will be set up, market rules will bedeveloped, a small portion of the market will be openedto competition on an auction basis, and there will besome energo restructuring (the nature of restructuring isnot detailed in the plan). In phase 2 of stage 1, alsolasting 18 months, market rules will be further devel-oped, merit order dispatch will begin, and there will befurther energo restructuring with possible mergersbetween regional companies. In stage 2 of the reforms,set to last 2 or 3 years, RAO will be split intotransmission and generating companies, market ruleswill be finalised and implemented, and regional marketswill be developed. In stage 3 (by far the most vaguelydefined reform stage), lasting 3–4 years, retail competi-tion will develop, and transmission will be merged withdispatch. It is hoped that competition will be fullyfunctioning and investment finance will begin to flowinto the sector at this time.One early reform measure that has already been

implemented is the setting up of a market operator on 23November 2001. The operator will have responsibilityfor developing the market rules, as well as paymentsettlement and clearing. The 28-member Board of theoperator comprises representatives of RAO, otherpower generators, government officials and majorconsumers.

6. Reform plan issues

6.1. Price and regulatory reform

Price reform is central to the success of power sectorreform in Russia as in other transition economies.26

Given the low level of prices current and the high energyintensity (see Section 2 above), increased prices wouldyield multiple benefits: currently wasteful consump-tion—in industrial and residential sectors—would fall tomore economically efficient levels; an environment forcommercialisation (e.g., through long-term businessplanning) and introduction of new international strate-gic investors would be created; finance for investmentsto increase thermal efficiency and reduce losses would beunlocked.The subject of the current paper is liberalisation of the

Russian power sector, and in this respect price reform isalso key—without price reform, then liberalisationcannot succeed. Clearly, when price is below cost thenthere is no incentive to supply a liberalised market. Thecurrent situation is one where prices are below long runcost,27 so without price reform, generating companieswould lose money supplying to the market, particularlyas investments are undertaken.An additional problem comes from the fact that there

is currently cross subsidy between large consumers andresidential consumers (the former currently pay morethan the latter). As markets are liberalised, prices beginto reflect costs for each consumer category. Given thecost structure of the power sector—large consumers arecheaper to supply than residential consumers—residen-tial tariffs should become higher than those for largeconsumers in a liberalised setting. If prices cannot berebalanced—the relative price of residential consump-tion increased—then this could undermine the liberal-isation effort. For example, if industrial prices fall butresidential prices are not increased to offset this, then thefinancial viability of power distribution companies willbe challenged, and the legitimacy of liberalisationquestioned (as it has been in California).The solution here is to rebalance prices to reflect costs

prior to liberalisation, and then to allow prices toincrease with cost as investments are undertaken. Thebest way to facilitate such price reform is to divorce thisfrom the political process through introducing a frame-work of independent regulation operating on the basisof clear and transparent rules. When these institutionalaspects are not in place, then experience from theregion—Kazakhstan in particular28—shows that pricereform is difficult to achieve. Within a strong regulatoryframework, on the other hand, there has been somesuccess in raising prices to reflect costs.29

Another aspect of the price reform relates topayments discipline: even if tariffs were to reflectcost, effective tariffs would not reflect cost due to

26See EBRD (2001) for a detailed discussion.

27Stern and Davies (1998) argue that 8 cents/kWh is a good proxy

for long run cost in the power sector. This may be adjusted down

slightly for large consumers which are slightly cheaper to supply when

linked directly to high-voltage networks.28See Kennedy (2002).29See EBRD (2001).


non-payment. This is a problem in Russia, where cashcollection (the amount of cash collected over totalamount billed) is around 80%. In addition, there aresignificant commercial losses—non-billed consumptionthrough illegal system connection or meter tampering—by western standards.30 If effective prices remain belowcost recovery levels, again this could undermine liberal-isation. For example, it may be the case that largeconsumers currently cross subsidise non-paying residen-tial consumers; should large consumer prices fall, thenthere will be a deficit for the distribution companyselling to residential consumers, with consequences asdescribed above.Experience from the region31—Georgia, Kazakhstan

and Moldova—suggests that payments discipline can bebest improved through introduction of strategic inves-tors to the supply business. Given the difficultiesimproving payments discipline without strategic inves-tors (the experience in Ukraine is illustrative here), thewisdom of proceeding with liberalisation before theintroduction of strategic investors in distribution may bequestioned. One way forward without strategic investorsin distribution is to allow a component of tariffs (e.g., aconsumer surcharge) to reflect commercial losses. This isnot ideal, however, because it allows continued non-payment), and measures to tackle payments disciplineshould be introduced as soon as possible.Turning to the reform plan, the need to increase

tariffs to reflect costs—both capital and operating—isnoted. Furthermore, tariff mechanisms for the variousindustry components (e.g., transmission and distribu-tion networks) are envisaged as being drafted in the firstphase of reform. Though there is a section in the plan onregulation, there is no mention of independent regula-tion, and of how federal/local regulatory interaction willbe structured (political input in regulation often comesat the local rather than federal level, so adequate powersin the centre are required if this is to be countered).Going forward, it will be a key challenge to develop astrong regulatory framework—both in terms of regula-tory independence and regulatory rules (tariff settingmechanisms). As regards introduction of strategicinvestors to counter commercial losses, this is notmentioned in the plan, though restructured energosmay opt to introduce such investors to improvepayments discipline and increase profit.

6.2. Competition and the structure of

generation/distribution

The reform plan does not refer in detail to the post-reform ownership structure that is envisaged for the

industry. In particular, the plan does not elaborate onthe extent to which assets will be unbundled. Under theplan, it is a possibility that energo generation anddistribution assets will retain common ownership withina holding company structure. Furthermore, there is nomention of how many generating companies there willbe overall, or in each of the envisaged regional markets.These ownership issues are key to the evolution of acompetitive market.One of the lessons to come from liberalisation of the

market in England and Wales—often used as a modelfor sector restructuring—is that this can be underminedif there is too much market power in generation. Clearly,if there is only one generator in the market, then therewill be scope for monopoly pricing. This holds in acontext where there are a small number of generators,demand is uncertain, and total capacity is restrictedrelative to demand. Then each generator can cause acapacity deficit by withholding its plant from themarket. The profit-maximising strategy for such agenerator is to offer supply at a price above what wouldprevail in a competitive market; this happened inpractice in England and Wales where the two dominantgenerators (National Power and PowerGen) offered tosupply power at high price–cost margins.32 Where thereare a large number of small generators, there is lessscope for individual generators causing system capacitydeficit, and thus less incentive to raise price above cost.In the case of England and Wales, it is likely that if therehad been five generating companies formed when theindustry was privatised rather than two, then marketprices would have been substantially lower in thefollowing years. Though new entry33 can exert compe-titive discipline on incumbent generating companies, thisis likely to be small scale in the short to medium termand thus of limited importance in this context.This argument may be applied to the case of Russian

power restructuring in determining how best to packageexisting generation assets for sale to strategic investors.In discussing this problem it is useful to distinguishbetween energo-owned CHP plant and RAO-ownedlarge power generating plant. Regarding CHP, thiscomprises 35% of the total generating capacity.Depending on the way that CHP plant is bundled inthe restructuring, companies with market power might

30Accurate data on commercial losses is not publically available.31See EBRD (2001) for a discussion of experience in Georgia,

Kazakhstan, Moldova and Ukraine.

32For analysis of this situation see Green (1991), Greene and

Newbery (1992), von der Fehr and Harbord (1993). These papers show

that in order to enjoy market power, a generating company need only

control a significant proportion of marginal plant as opposed to total

installed capacity. For example, a generator owning all mid merit and

peaking plant in a system but no base-load plant would have market

power even though its share of overall system capacity might be low.

CHP plant in the discussion above can be regarded as equivalent to the

marginal plant in these papers.33For example, in England and Wales, new entry occurred through

Independent Power Producers: stand-alone generating companies in

long-term off-take agreements with regional distribution companies.


be created, e.g., if all CHP assets within a region subjectto transmission constraints (i.e., with restricted importcapacity so that competition from national powersuppliers is limited) are commonly owned. In otherwords, a situation might be created where certaincompanies are able to dominate regional markets,offering to supply to what could effectively be a captivemarket at a high price relative to cost.A way to avoid this situation would be to create

multiple generators within regions. Clearly, this shouldbe within the bounds of what is technically feasible; i.e.,no generating company should be smaller than theminimum efficient scale. Companies should also besufficiently large to attract investors; this might requirebundling of assets across regions (i.e., a generatingcompany may own a number of subsidiaries eachcompeting in a different regional market). Table 1shows the size of various privately owned powergenerating plants/projects in transition economies.34

By comparison, it would seem that Mosenergo with aninstalled capacity of 15GW could potentially be brokeninto a number of generating companies. If United Statescompetition rules were to be applied, which prevent anycompany from having a market share exceeding 20%,35

then Mosenergo would be broken into (at least) fivecompanies each with 3GW of generating assets. Thedesirable extent of unbundling for other energos shouldbe determined on a case-by-case basis taking intoaccount potential market power, this being dependenton regional market size, transmission (import) con-straints, and energo installed capacity.If generating assets within a region are to be

commonly owned, then the potential for abuse of

market power can be reduced by regulation. Forexample, the regulator might benchmark CHP plantsagainst each other and impose a price ceiling. This is notideal, as the regulator cannot match the market in termsof discipline exerted on companies.36

The regional markets proposed in the plan should,wherever technically feasible (depending on configura-tion of the transmission network), cover an areacurrently served by a number of energos (e.g., theremight be five or six regional markets) in order that thereare multiple market players. It is envisaged thatrestructuring will result in the formation of 40 energosrelative to the current 74. This proposed consolidationwould lead to an even greater concentration of localgenerating assets if these were to remain commonlyowned with distribution. In such a situation, regulationof generation would be appropriate. To repeat theabove, however, this would not be ideal, and would limitthe pressure on generating companies to performefficiently. More desirable would be to unbundleenergos’ generating assets and sell these off as compet-ing generation companies.There are additional arguments for separating own-

ership of generation and distribution assets which relateto the ability of integrated companies to foreclosemarkets and thus to prevent the evolution of competi-tion. For example, an integrated company can raise therelative costs of its generating competitors and thus gaina competitive advantage by allocating some generationcosts to the distribution business.37 Competing inte-grated energos within a regional market might engage inthis type of behaviour and in doing so would underminecompetition.The best way to prevent market foreclosure is not to

allow integrated ownership of generation and distribu-tion.38 A proviso must be made here: in very smallregions, e.g., where there is only CHP plant and noother generation, and where this forms part of the leastcost dispatch plan, then there may be no benefit fromseparate ownership, and some scope economies fromjoint ownership. This point is relevant for some smalland remote regions in Russia (e.g., Buryatia).For larger regions, where there is more generating

capacity, and more danger as regards distorting the levelplaying field (either as regards local generators orimports from the national market), it is relevant to notethe proposals by the European Commission to preventjoint ownership of generation and distribution, and thelimited efficiency gains in Scotland—where integration

Table 1

Size of private power plants in transition economies

Country Plant Size (MW)

Hungary Bakonyi 180

Budapesti 120

Dunamenti 1900

Martra 800

Paksi 1840

Pecsi 196

Taszai 1300

Vertesi 375

Poland Patnow 2700

Polaniec 1800

Bulgaria Maritsa East 1 670

Maritsa East 3 900

Source: EBRD internal data.

34There has been limited privatisation of generating companies in

transition economies, hence the narrow country coverage of the table.35See US Department of Justice Merger Guidelines, issued 14 June

1984. In the European Union, the European Commission may regard a

market share in excess of 25% as a problem.

36The result would likely be inefficient dispatch, manifest in plants

operating at the wrong capacity factor and/or with the wrong power/

heat mix.37See Kennedy (1997) for a discussion.38Newbery (1999) is a strong advocate of this point of view.


was allowed) relative to England, where integration wasbarred (see Section 3).The proposals by the European Commission were

designed to overcome problems regulating integratedgenerating and distribution companies even when theseentities keep separate accounts (a requirement under theEC Power Directive); even in a context of accountingseparation, regulation is difficult, and there may begaming opportunities for integrated companies prevent-ing network access for their competitors (manipulatingaccounts and/or providing technical barriers). In thecase of Russia, as elsewhere, there is the possibility ofregulatory failure, which might allow market foreclosureand thus prevent competition between energos. On topof this, the CHP dimension—if heat and CHP areintegrated, and assuming that there is not retailcompetition in the heat sector, then there is no heatoff-taker for potential new entrants in generation—provides a strong argument for separate generation anddistribution ownership.If separate ownership is not feasible then accounting

separation of generation and distribution provides abasis for regulation, and is an improvement on thepresent situation, where accounting information is notconducive to effective regulation.39 The problem inachieving full separation of generation and distributionin the Russian context is that this would requireapproval of current shareholders. There is a conflict ofinterest for shareholders here, in the sense that agreeingto separation could reduce profits (through increasingcompetition) and shareholder value. If separation is notfeasible, the aim should be to introduce a set of costreflective regulated network access prices based oninformation from separate accounts, with the regulatorensuring that all third parties have equal access to thenetwork.Regarding large generating companies currently

owned by RAO, these will potentially form the nationalcompetitive market (i.e., they would provide the basisfor regional power imports). Power sold on thesemarkets would make up the deficits in demand andsupply in regional markets. The points above in thecontext of CHP competition apply in the case of thelarge generating companies: there should be a sufficientnumber of companies that no one company enjoysmarket power and the ability to manipulate the marketprice. As in the case of CHP, companies should be assmall as possible subject to technical and financialconstraints. One possibility is that large generatorscould be bundled with CHP assets in different regions tomake companies sufficiently large to interest investors,

yet still provide multiple players in the national andregional markets.Progress has been made in restructuring of the large

generating companies with submission of a proposal byRAO to the government on 19 November. The proposalis to create 10 generating companies, four of whichwould be hydro and six thermal. The thermal companieswould comprise five–six plants (with combined capacity8–10GW) in different regions, this in order to limitmarket power of any one company within a region.Mosenergo would be required to divest 5GW of plant—four large power stations—as part of the proposedrestructuring. RAO has not yet published analysisunderpinning company formation to demonstrate thatthe proposed configuration would indeed supportcompetition.Regarding restructuring of energos vis-"a-vis CHP

plant, this is not mentioned in the restructuring plan.RAO is currently considering draft restructuring pro-posals submitted by the energos. RAO must approverestructuring proposals if they are to be implemented,though it cannot impose restructuring on the energos,which requires 75% Board approval at the energo level.The general flavour of the restructuring proposals is tokeep common ownership of generation and distributionwithin a holding company structure possibly with someconsolidation between existing energos. If these propo-sals are accepted—this would not be the first bestoutcome—then regulation of distribution with a view tocreating a level playing field for network access will be akey challenge, and there may be a need for someregulation of CHP companies to prevent abuse ofmarket power.

6.3. Transmission: ownership and pricing

The reform plan contains clear proposals for therestructuring of transmission ownership and systemoperation; these will be separately owned for an interimperiod, with integration at a later stage, and continuingindependence of both functions from generation.From a theoretical point of view, an integrated

generating company and system operator may departfrom merit order dispatch and instead send out its ownhigh-cost producer. The solution here is to preventintegrated ownership of generation and system opera-tion. This may imply that generation and transmissionshould be separately owned, to the extent that transmis-sion and system operation are integrated. One argumentfor integration of transmission and system operation isthat this type of company is straightforward to set upfrom a state-owned, fully integrated industry. Thealternative, to set up a separate system operator,typically involves high transaction costs. Against theargument for integration is that transmission andsystem operation companies, driven by the commercial

39 It is likely that heat production—without competition between

CHP generators—would be inefficient in this context. Though there

might evolve some competition with gas, this is not currently used for

purposes of heating.


objective to maximise investment,40 may favour trans-mission-based rather than generation-based solutions tocongestion (i.e., increasing transmission capacity into aregion rather than increasing generation capacity in theregion). Integrated transmission and generation compa-nies may take a more global view of investment. It hasalso proved hard in practice to provide integratedtransmission and system operation companies withincentives to minimise generation costs when departingfrom the ideal merit order, whereas this can be writtenas an objective for a (non-profit making) systemoperator.41 Where transmission pricing reflects conges-tion, there may be incentives for integrated companies tomanipulate dispatch in order to gain congestion rents;this is an argument for separation of transmission andsystem operation.Both models (integrated and separate transmission

and system operation) have been implemented invarious countries as part of power sector reform andthere is no clear evidence as yet to support one over theother. Each model can function in the correct institu-tional setting.42 The important point is that systemoperation should be impartial. If transmission andgeneration are integrated, then system operation shouldbe separate from transmission. If transmission isseparate from generation, then there is no reason toseparate transmission and system operation, providedthat effective regulation of transmission is in place.43

The Russian power sector reform plan is consistentwith these principles of transmission and systemoperation ownership. The plan envisages that ownershipof transmission and system operation will remainseparate while RAO still has interests in generation.This is particularly important given the experience todate where RAO has used its position as systemoperator to inhibit potential competitors’ networkaccess. Going forward, the planned integration oftransmission and system operation after RAO hasdisposed of its generating interests will not be proble-matic as there will be no incentive for the integratedcompany to favour certain generators. The proposal tokeep transmission as a state-owned company, while thismay not affect the evolution of competition, may raisetransmission prices. It is important that transmissionand system operation are organised along commerciallines if operating and investment functions are to becarried out efficiently, and it is likely that the best way toachieve this is through introduction of the privatesector. To the extent that this is appropriate only when

a regulatory framework is in place, there is a case fordelaying privatisation in the medium term.Another important aspect relating to liberalisation is

transmission pricing; depending on how prices are set,dispatch/new entry in generation may not be economic-ally desirable. For example, transport of power overlong distances will be encouraged where transport costsare averaged over all generators in the system. In fact,traditional pricing mechanisms have been based onsome form of averaging. If economically optimaldispatch and entry decisions are to be made, thentransmission prices should reflect underlying costs.More recently, pricing mechanisms have been developedthat capture underlying costs and that can be imple-mented in a straightforward manner.44 In the case ofRussia, cost-based pricing is particularly importantgiven the long distances over which power maypotentially be transported. The reform plan envisagesthat a transmission tariff mechanism will be developedduring the first stage of reform, though no principlesfor the mechanism are stated. RAO has recentlyengaged an international consultancy company todevelop a location-specific transmission network tariffmethodology.

6.4. Market rules

There are various models for market liberalisation,each of which could be implemented in Russia under thereform plan. One of these models—featuring in theEuropean Power Directive—is to allow bilateral con-tracting between generators and large consumers (in-cluding power distribution companies/suppliers). Underthis model, generators and consumers conclude con-tracts with each other and then pay a network access feeto the transmission and distribution companies.In England and Wales, the United States and

Scandinavia, competition has been introduced in theform of a power pool. A pool normally involves amarket operator taking bids to supply from generatorsand demand-side bids from large consumers anddispatching and plant where supply and demand-sidebids are equal.45 The market operator subsequentlycollects revenues from distribution companies and largeconsumers and makes payments to generators accord-ingly. Pools may operate at the national or regionallevels or both simultaneously.Advocates of power pools argue that they are more

competitive than contract-based markets due to lowertransaction costs.46 Even at this level, the transaction

40This applies more to a system where there is not free entry in

generation.41See Newbery (2001) for a discussion of how to provide incentives

to transmission companies.42Arizu et al. (2001) elaborate this view.43See Newbery (2001).

44See Kennedy (2002) for a discussion of alternative forms of

location marginal pricing.45 In order to ensure impartial dispatch, and as with transmission,

system operation, and distribution, market operation should be

independent from generation.46Hogan (1998) compares pools and contract-based markets.


cost argument was rejected in the case of England andWales, which moved from a pool to a contract basedmarket in 2001.47 In contrast, a pool was the chosenmodel in California. The debates leading up to thesechoices did not take into account governance andinstitutions (in the sense outlined below); considerationof these aspects is important when considering which isthe most appropriate model for transition economypower sectors.Looking first at a pool, technical requirements (e.g.,

data, communication, software) can be very demanding.The number of transactions that takes place in a poolmay be taxing from an institutional point of view. Pricesin power pools are typically volatile, and though relatedrisks may be hedged through futures markets, these arenot always deep in the early stages of liberalisation.Incentives for collection of payment in a pool may bemuted given that the market operator typically does notsuffer financially for a failure to collect.When the pool acts as a clearing house, this can

provide opportunities for corrupt behaviour. In addi-tion, there are additional potential governance problemsregarding how scarce funds—when there are paymentproblems—are to be allocated amongst generators. Athird area where governance may be a problem isdispatch and whether or not this will be according toeast cost principles or whether political/cultural fac-tors—even when the market operator is separate fromgenerators—will be important. A fourth area wherethere may be cause for concern relates to governance intimes of crisis; this has been an issue in California andChile (see Section 4).Competition on a contracting basis, on the other

hand, is reasonably straightforward to implement froma technical and institutional point of view. Thegovernance problems associated with pools are absentunder a contracts model (because funds do not flowcentrally, and dispatch is not centralised). Contracts areattractive for these reasons, and also because thepossibility of long-term contracts in such marketsprovide adequate security for investors to go aheadwith projects. Incentives for cash payment are strongunder bilateral contracts; a generator will not continueto supply a non-paying customer.In the case of transition economies, where there may

be technical and institutional capacity constraints,where payments discipline is a problem, and whereinvestors are subject to a possibly prohibitive multitudeof country and sector risks aside from those associatedwith the market (i.e., market risks should be minimisedto secure investment), contract-based competition islikely to be more appropriate than a pool, at least in themedium term (i.e., until there has been progress on the

technical and institutional fronts and as regardspayments discipline).48

Turning to evidence from transition economies(recapping and elaborating Section 4), a power poolwas introduced in Ukraine in 1996. This has failed tofunction in the face of poor payments discipline. Inparticular, limited funds are allocated on a non-transparent basis according to a frequently changingalgorithm. Allocation of funds is such that certaincompanies are unable to cover operating costs and haveinsufficient cash to purchase fuel even when they may bemore efficient than companies which are able topurchase fuel. Furthermore, dispatch in the Ukrainianpool is not least cost. Finally, the pool has not been acatalyst in terms of achieving sustained improvements incash collection.49

There is a similar situation in Georgia, where againthe centralised market operator has been unable totackle payments problems, and where there is asubstantial deficit as regards its payables vis-a-vis itsreceivables, and where cash flows actually reachinggenerators are insufficient to cover operating cost. InKazakhstan, on the other hand, a bilateral contractsmarket has sustained over several years, with continuedsupply in a difficult environment where paymentsproblems are on a comparable scale to those in Georgiaand Ukraine.Turning to the situation in Russia, payments dis-

cipline is a problem (see Section 6.1), though not to thesame extent as in Ukraine or Georgia (where cashcollection is around 50%).50 Nevertheless, cash shortfalls in a Russian pool could be sufficient to causedifficulties as regards allocation of funds, and theconsequences that this could have for generators cashflows and continued willingness/ability to supply themarket. On sector governance, we know from pastexperience that though the arrangements were in placefor merit order dispatch, this did not take place inpractice (see Section 2). For these two reasons, togetherwith the fact that long-term contracts provide securityfor investments, a bilateral contracts model may bemore suitable than a pool for Russia.If a contracts market is adopted as the chosen model

for Russia, it must be recognised that the market willnever be fully contracted in the sense that contracteddemand will always be less than total demand (becauseconsumers aim to avoid costly over-contracting). Giventhat this is the case, then arrangements should be inplace to supply residual (non-contracted) demand. Thestandard mechanism here is to have a balancing pool,

47See OFGEM (1999).

48Lovei (2000) argues that competition on the basis of bilateral

contracts is appropriate for transition economies. Besant Jones (1996)

argues that power pools are unsuitable for developing countries.49Nosov (1999) provides a detailed account of power sector reform

in Ukraine.50See EBRD (2001).


that is, a pool for non-contracted demand. Though abalancing pool may suffer from problems associatedwith a full pool, these would be on a smaller scale, andtherefore potentially less disruptive to the sector.If a full scale pool is to be the chosen option, then this

should not be along the lines of the model adopted inCalifornia, which was expensive to develop (it cost $100million and took 4 years to get started) and isdemanding to implement. This cost could not bejustified against the expected benefits in Russia, wherethe likely success of such a pool is lower than inCalifornia for the reasons discussed above. Much of thepotential benefit from a California type pool could beachieved through a simpler and cheaper pool mechan-ism. Such a mechanism might have one (rather thanmultiple) markets, with some time of day pricing—within the constraints imposed by current metering—but not real time pricing, with the possibility of a limitednumber of large consumers buying directly from thepool (and other large consumers free to shop arounddistribution companies acting as wholesalers).Governance problems could still be a problem in this

type of pool. One way around this—to achieveimproved payments discipline, transparent allocationof funds, and merit order dispatch—is to contract outpool management to the private sector. This approachwas recently adopted in Georgia, though it is too earlyto tell whether this will be successful or not in improvingthe functioning of the market and the sector as a whole.Regarding security for investors, this could be providedby making the pool non-mandatory, allowing bilateralcontracts outside the pool; this approach was adopted inEngland and Wales after liberalisation, where long-termcontracts were required to secure investment finance.Turning to the Russian reform plan in respect of

liberalisation, no specific model is mentioned. Astatement that ‘‘market pricing should be carried outbased on the comparison of price bids of buyers andsellers’’ is consistent with the introduction of a pool.Contracts are not ruled out under the plan, and draftlegislation developed since the plan was adopted appearsto advocate a bilateral contracts market together with abalancing pool, though there is some ambiguity here(other parts of the legislation suggest a mandatorypool), and further drafting will be required. The messagein this paper is that given the Russian context, a bilateralcontracts market with a balancing pool would be mostsuitable.

6.5. Supply competition

Liberalisation of supply is proposed under the reformplan. Generally, supply is regarded as being competitivefor large users (typically above 100 kW). In this marketsegment, the distribution company provides the dis-tribution service at a specified cost, and any supplier

(either a generating company or a wholesaler) can thennegotiate contracts with the customer to cover thepurchase of power, use of the transmission system, useof the distribution system, and metering/billing.Metering and billing of residential customers is

typically organised as a regulated monopoly operatedby the local distribution company. The reason for this isthat in most countries (particularly transition econo-mies) substantial investments in metering, data commu-nication and software (for financial settlement betweenretail suppliers and generators) would be required inorder to make this function competitive.Though some countries have liberalised metering and

billing (e.g., England, Finland, Norway), there is noevidence yet available to suggest that such investmentsare economically justified. The cost reductions thatwould ensue from competition may not cover therequired investment costs (which are passed on to theconsumer in the form of a system levy). For example,the cost of introducing competition in England andWales amounted to d720 million, this to be set againstthe d600 million total operating cost of the power retailsupply businesses. In light of this, many countries haveopted to delay opening the market for small consumersuntil a later stage (e.g., Germany, Netherlands andSpain are planning to open small-consumer markets in2007).In the case of Russia, though there are potential

benefits available in metering and billing, these are smallrelative to the overall tariff (because metering and billingcosts are small relative to total costs), and it is likely thatthese can be unlocked (largely) through effectiveregulation rather than competition. If this holds, thepriority should be to introduce effective competition ingeneration and large-user supply, and effective regula-tion in other parts of the business. Liberalisation of thesmall-consumer market should not be a short-termpriority given the huge institutional demands of theseother reform challenges. The reform plan is consistentwith this approach, envisaging that supply competitionfor large users will be introduced in the second stage ofreform whilst supply competition for small users willstart from the third reform stage.

6.6. Sequencing

Price reform prior to liberalisation is key if the latter isto succeed. At a minimum, price rebalancing betweenlarge and residential consumers is required if thefinancial viability of distribution companies is to bemaintained. In addition, average prices should also beincreased to cover operating costs in regions where thisis not already the case. Though price reform shouldideally take place within a context of strong regulation,this is not a necessary condition: a tariff increase now,before the development of new regulatory institutions


would provide an interim solution. Regulatory reform iskey, however, and should move forward sooner ratherthan later if private finance for necessary investments isto be mobilised.Given the experience of competition in the Russian

power sector to date—and as noted above—a separatesystem operator should be set up to ensure that allgenerators have access to the transmission network onequal terms. Phased opening of the market would beundermined if a separate system operator is not in placefirst (e.g., because non-RAO generators could be deniedaccess to the network). This point applies to an extent asregards the market operator: this should also beseparate, particularly from RASO (to avoid the sameproblems that could occur through integration of systemoperation and generation). If a bilateral contracts modelis the basis for competition, then the separation of themarket operator becomes less important as scope fordistorting the market through this function is dimin-ished.Competition could proceed before energos are re-

structured, that is, whilst they remain vertically inte-grated. It is necessary however that a distribution tariffmethodology is in place before liberalisation in orderthat all potential market participants have equal net-work access. In order to implement such a methodology,ideally separate accounts should be available fordifferent energo functions. To the extent that these willcome about as part of the energo restructuring process,then there should be a link between the timing of thisand market opening.More generally, liberalisation can proceed without

ownership restructuring given that system operationremains a non-RAO activity. Ownership restructuring(consolidation of RAO shares in transmission, andcurrent minority shares in energos) requires furtherwork on valuation, which in turn will require betteraccounting information on assets involved, and tariffmethodologies for different industry components. For-mation of new large generation companies, and sale ofthese to multiple investors, is necessary if liberalisationis to have any deep effects. With the current consoli-dated ownership of generation, it is unlikely that therewill be deep competition, with RAO interests ingeneration being challenged only by very small compa-nies (e.g., industrial own generators).A transmission price methodology and grid code

should be in place prior to liberalisation. In the absenceof a cost-based transmission pricing methodology,dispatch may not be geared to minimise system cost.Without a well-defined set of market rules, investmentfinance to the sector may be limited. Without a gridcode, not all market players may have equal networkaccess. The plan recognises these potential problems andenvisages that rules and institutions will be in placebefore markets are liberalised.

Regarding the market rules, if a pool is the chosenmodel, then this should not be implemented until waysof dealing with non-payments problems have beenfound. Either full liberalisation should delayed untilpayments discipline is no longer a problem, or arrange-ments should be in place to ensure that non-payers donot have continued access to a pool, and scarce poolfunds are allocated in a manner to support efficientmarket operation. Alternatively, and as argued in thispaper, a bilateral contracts model may be more suitablefor Russia, and could be introduced earlier.Whether contracts or pools are chosen, competition

will necessarily be simple at first, For example, contractsmay be volume based whilst there is insufficientmetering in the transmission/distribution networks fortime of day pricing. Notwithstanding this, remetering ofnetworks is a priority because time of day pricing canyield substantial efficiency gains and at relatively smallcost. Going forward, more sophisticated mechanismsmay be introduced, e.g., an exchange where contractsmay be traded, or a full pool (e.g., with demand sidebidding).In the interim period before liberalisation, long-term

contracts signed between generators and off takers(either RAO, the distribution companies, or largeconsumers) to support new investment should beavoided. Evidence suggests that contracts signed in anon-market environment are often uneconomic and turnout to be unsustainable after liberalisation,. This canlead to stranded cost problems, anticipation of whichcan slow down the liberalisation process In the case ofRussia compared to—say—Poland, stranded costs arelikely to be less of a problem, given the lack of recentnew investments / long-term contracts.51

Finally strategic investors could contribute to im-proved performance in the Russian power sector.Though liberalisation could proceed with the countryset of industry owners, early introduction of strategicinvestors would maximise benefits from liberalisation.

7. Conclusion

There are many good aspects of the government-approved reform plan for the Russian power sector.These include the proposals to create separate marketand system operators and to separate transmission fromgeneration and distribution. There remain a number ofareas, however, where proposals are not fully specified,with the possibility of outcomes that would not supportthe objective to successfully liberalise the power market.In particular, it is not yet clear whether generating anddistribution assets of energos will become separately

51See Kennedy (1999) for a discussion of long-term contracts in a

context of liberalisation in transition economies.


owned. For the larger energos, it is not clear whethergenerating capacity will be divested to reduce potentialmarket power. This paper has argued that price andregulatory reform are key to the success of liberalisation.On structure, ideally generation and distribution shouldbe separately owned, and that breaking up the genera-tion assets of some energos should be considered.Regarding market rules, it was argued that there is astrong case for allowing bilateral contracts betweengenerators and consumers. Moving to a fully fledgedpower pool without the possibility of off-take contractsmight undermine the reform effort. With the appro-priate industry structure and market rules, and in acontext of effective regulation, then evidence frompower sectors in other countries suggests that theobjective to achieve a high level of competition ingeneration and supply, and to secure inflow of invest-ments, can be achieved.

Acknowledgements

I would like to thank Ian Alexander, Sergey Bubnov,Peter Sanfey and an anonymous referee for comments.Views expressed are my own and not necessarily those ofthe EBRD.

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