Power & Utilities in Russia

Industry overview and investment opportunities—May 2016

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Power & Utilities in Russia

Power market overview (1/2)

Coal / gas stations

66%

HPP17%

NPP16%

Other1%

Unbundling of RAO UES

One of the key processes that greatly shaped the current state of the industry was energy reform during 1998-2008.

A key part of this process was the so-called “unbundling”, i.e. the separation of electricity distribution (where competition is impossible) from generation and retail / reselling (where competition was introduced). An important step in this was the break-up in July 2008 of RAO UES, a former state-owned quasi-monopoly.

Other key amendments were the liberalisation of electricity prices and the creation of a day-ahead power market based on a merit order model.

Key statistics

As of 2015, Russia is the fourth-largest electricity producer (1,104 TWh) and the fourth-largest consumer (986 TWh) in the world.

Sources of electrical energy generated in Russia:

— Coal / gas stations: 730 TWh

— Hydroelectric power plants: 191 TWh

— Nuclear power plants: 179 TWh

Total length of transmission lines:

— High-voltage grids: approx. 140,000 km

— Low-voltage grids: approx. 2,200,000 km

10%15%

20%30%

35%

55%65%

85%

100% 100%

5% 10% 15%25% 30%

50%60%

80%100% 100%

0%

20%

40%

60%

80%

100%

120%

H12007

H22007

H12008

H22008

H12009

H22009

H12010

H22010

H12011

H22011

Market liberalisation

Source: Government Decree No. 643

Note: The graph shows ranges of electricity supplied to the day-ahead market to total volumes supplied to the wholesale power market (except for volumes supplied to residential consumers). The dark blue bars represent the lower end of the range, while the light blue bars represents the upper end

Sources of generation in Russia

Source: EIU data

Transmission network operatorsTransport power via high-voltage lines

Regulated

Generating companiesProduce power

Liberalised

Distribution network operatorsTransport power via medium / low-voltage lines

Regulated

Retailers / supply companiesSell power to end consumers

Partially liberalised

RAO UES of Russia

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Capacity reserve in Russia

During the reform an active discussion took place of the need to build new power capacities in the early 2000s. These discussions were summarised in the form of the so-called “Chubais cross” (named after the former Energy Minister Anatoly Chubais).

The capacity reserve in Russia was around 19% in 2007, on the eve of the power market launch.

Actual demand for power was lower than the projected numbers: RAO UES expected that the annual growth rate of electricity consumption would be up to 4-5% for 2007-2020, while according to Rosstat the actual growth of power consumption for 2007-2013 was approx. 0.6%. This resulted in the power reserve reaching 55% in 2013.

Currently the Russian Ministry of Economic Development is revising a new power capacity commissioning programme, primarily of HPPs and NPPs (CHP commissioning, in accordance with a capacity supply agreement (CSA), is almost completed), as their commissioning can significantly increase the burden on consumers. In addition, new incentives for generators to decommission old, inefficient generating units are being developed.

Current structure

RosEnergoAtom (nuclear)

RusHydro (hydro)

Service / repair companies

Sales companies

Other generating companies

14 TGK companies

6 OGK companies

Far East Energy Company

Isolated AO-Energos

Trading system administrator

Federal Transmission Grid Company

(FSK UES)

Interregional Distribution

Grid Company (Rosseti)

System operator

State-owned share

>50%<50% >75%

Infr

astr

uctu

re

Com

petitive sphere

Plans for commissioning new capacity

Source: Russian electrical system development scheme, 2015-2021

0,88 1,152,26

1,13 1,17

0,27 0,32

0,43

0,45

5,38

1,92

2,37

1,08

0,78

0,23

0,2

0,35

0,29

0

2

4

6

8

2015 2016 2017 2018 2019 2020 2021

GW

NPP HPP TPP Renewables

Plans for decommissioning installed capacity

Source: Russian electrical system development scheme, 2015-2021

0,421 1

1,67

2,35

0,86

0,17

0,02

0,04

0

0,5

1

1,5

2

2,5

3

2015 2016 2017 2018 2019 2020 2021

GW

NPP TPP

Power & Utilities in Russia

Power market overview (2/2)

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Power & Utilities in Russia

Overview of heat supply

Current state

Overall, the heat supply in Russia faces a number of challenges, which are summarised in the diagram below. Many experts claim that these problems stem from the power reforms of 1998-2008, which did not take into account the specifics of heat generation. It is rumoured that new heat supply reforms will be introduced, and that certain steps have already been taken (e.g. a switch to a new tariff-setting mechanism – the so-called alternative boiler method).

Key statistics

Heat generation in Russia stands at around 850 million Gcal, or 50% of the world’s generation.

Most of this (75%) is generated in the central district heating system (with most energy generated by boilers), while the central district heating system in comparable countries of Northern Europe accounts for approx. 30% of heat production (most heat is generated using the cogeneration cycle).

Inefficient ownership structure Low transmission tariff Low collection rates

Failure to use advantages of cogeneration

Lack of operating costs’

optimisation

Loss from operating activities

Working capital requirement

Lack of funding sources

Ineffective capital

expenditure management

High average generation

tariff

High accident rate and level

of losses

Requirement of subsidies

from the budget

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Power & Utilities in Russia

M&A activity

Activity in 2014-2015

— The total value of P&U deals in 2015 was down by 86.6%, to USD0.7 billion

— The number of transactions in 2015 was down by 36.4%, to 14 deals

— The P&U sector accounts for 1.3% of the Russian M&A market

— Largest P&U deals in 2015 (> USD100 million):

− acquisition of a 60% stake in St. Petersburg Electric Networks, Petrodvortsovaya Elektroset, by Lenenergo from the St. Petersburg Municipal Government

− acquisition of a 9.7% stake in Inter RAO UES by United Capital Partners from Norilsk Nickel

− acquisition of a 100% stake in Transmash-energo by United Wagon Company from TM-Energo Finance

Outlook for 2016

— Based on a consensus of low oil prices with further downside risk, it seems that the CBR’s prediction of a further contraction of the Russian economy in 2016, if the oil price averages USD35 a barrel, could increasingly become a reality

— Inbound investment from Europe and the US looks likely to remain depressed, even if sanctions were lifted in the second half of 2016 following the Minsk ceasefire agreement being fully implemented

— Given continuing tariff pressure as the government tries to curb inflation, P&U companies are likely to focus on internal optimisations and aim at efficiency increases

— A certain level of M&A activity can be expected in heat generation (taking into account recent developments in tariff-setting – the alternative boiler method) and renewable generation (as a result of new tenders for capacity supply agreements)

P&U deal value and volumes, 2010-2015

Source: KPMG M&A Outlook, 2015

5,0 4,6 3,8 4,6 5,6

0,7

23

13

17

14

22

14

-

5

10

15

20

25

-

5

10

15

20

2010 2011 2012 2013 2014 2015

US

D b

illio

n

Mega deals (>USD 10bn) Deal value, excl. mega deals

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Power & Utilities in Russia

Key trends – Electricity

Consolidation

Depreciation issue

CIS integration

Investing abroad

No renewable generation

Limitations imposed on tariff growth

Continuation of asset consolidation by state-owned companies (GEH, RusHydro, InterRAO). Private investors tend not to invest in the industry

State-owned corporations are interested in investing abroad. In this connection there are certain rumours surrounding InterRAO and GEH

74% of thermal power plants were commissioned over 30 years ago (depreciation exceeds 75%), while around 50% of power grids are more than 30 years old. Replacement or refurbishment would require very substantial capital investments

Renewable energy in Russia comprises only HPPs. The share of other renewables amounts to approx. 1%; an increase to 15% is planned in the long term

The new power market is planned to unite the energy systems of Russia, Kazakhstan, and Belarus

Market participants need to find a way to finance their investment programmes –possible options include concessions (public-private partnerships) or transfers to strategic investors

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Consolidation

High level of losses

Tariff setting

Depreciation issue

Production of heat by boilers

The continuation of asset consolidation by state-owned companies. Private investors tend not to invest in the industry

74% of thermal power plants were commissioned more than 30 years ago (depreciation exceeds 75%), while around 50% of power grids are more than 30 years old. Replacement or refurbishment would require very substantial capital investments

Heat losses during production and distribution can reach up to 50%

Heat is often produced by boilers, which is less effective than production by CHPs. Trend: consolidation of municipal boilers and grids with generating companies, with a subsequent transfer of heat production to CHPs

New tariff regulation is under discussion, which should promote investments in the sector – alternative boiler method, united heat suppliers

Power & Utilities in Russia

Key trends – Heat

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© 2016 JSC KPMG, a company incorporated under the Laws of the Russian Federation, a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Russia.

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG International”).

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

ContactsThe contacts at KPMG in connection with this report are:

Vassily SavinDeal AdvisoryPartner, Head of P&U in KPMG Russia and CISTel: + 7 495 937 44 77 Mob: + 7 916 901 80 44VSavin@kpmg.ru

Vitaly YakovlevDeal AdvisoryDirector, KPMG Russia and CISTel: + 7 495 937 44 77 Mob: + 7 968 691 10 47VYakovlev@kpmg.ru