Russian Economic Reform

Past Articles on the work of each of the 21 Expert Groups can be accessed here:

Reform of “Natural Monopolies” – what to do?

Published on June 19 2011
Posted by: jeff

Group 18 started with some general reports on regulation of  “natural monopolies” and then moved on to some specific reports on railways, electricity distribution, and gas.

Jeff says that ….

(The Transport Minister has been reported as saying that 12% of Russian Railway may initially be put up for sale. However, he also said that “as much as 25% minus one share is scheduled for sale sometime later than 2013, after the monopoly sells stakes in its own units to raise investment funds”. What this means is that Russian Railway – quite correctly — needs to sell those parts of its operations that cannot be considered as “natural monopoly” operations. I make no claim to know a lot about technical issues associated with railways, electricity or gas — but the more general papers produced for this Group on competition laws, which I do know something about, seem reasonably sensible to me. Regulation and majority government ownership is not going to disappear. Is this bad? I think not. At the end of the day, the truth is that buying shares in a “regulated natural monopoly” is never going to give fantastic returns on the investments. Or, am I wrong?)

Regulation:

A report by some members of the Government’s “Financial University” looks at the aims of reforming “natural monopolies”, and makes these main points:

Existing reform of natural monopolies in the Russian electricity market has not considered the interests of the great majority of consumers, but has maintained the traditional power of the “suppliers market”, albeit in a new form.

The existing mechanisms of natural monopoly need to be improved to permit closer ties between producers and buyers (in electricity this means between generators and consumers).

Necessary to limit the level of market power in the competitive segment of the markets, including implementation of measures to lower the level of market concentration.

Necessary to maintain government ownership while “natural monopoly” reform is carried out. Even after reform, the state should continue to own particular parts of the natural monopoly sector (main gas pipelines, electricity distribution network, main railways infrastructure etc).

Networks should not be involved in vertical integration.

Dr. Kotelkina from the Federal Anti-Monopoly Commission (FAC) prepared a document on improving the regulation of natural monopolies:

Aspects of the traditional “natural monopoly” activities can be subjected to greater competition, while the remaining activities are regulated. Regulation should cover not only price, but all contractual relations between “natural monopoly” activities and customers.

An example of unsuccessful “reform” is the separation of the “maintenance/service” of gas equipment inside multi-apartment buildings from other aspects of gas supply. Development of competition in this “maintenance/service” area is hampered by other regulations which stipulate that only “gas-distribution” entities can carry-out such activities. The result has been that the gas monopoly is retained but the price for “maintenance/service” has been removed from regulation.

Regulations are often not specific enough in describing those good goods and services that are regulated. This is particularly the case in rail transport – for example, additional payments for some wagon breaking devices for loading.

When being connected to a network, it is not always clear if the consumer should separately be charged for the “last mile” – and this allows the regulated monopoly to demand additional payment from consumers.

Electricity: 

Drs. Derbedenev and Furshik of “Financial and Organizational Consulting” have produced a paper entitled: “Electricity: lower tariffs or investment?”

They argue that on the one hand it is obvious to all that increased investment is needed in the electricity distribution sector. On the other hand, many suggested solutions imply significant growth in tariffs. 

They say that the electricity sector needs to become more efficient in order to avoid tariff increase of tens of percentage points each year.

There are two basic players in Russian electricity transmission and distribution – FGC (Federal Grid Company) and MRSK-Holding (or IDGC-Interregional Distribution Grid Company). Both companies are ultimately controlled by the state (although there are also private shareholders). Both companies are less than efficient, with MRSK being the worst.

Much of the electricity distribution network is worn-out, and this is causing increasingly frequent black-outs and complicating the connection of new consumers.

A new system of tariffs is needed for МRSK-Holding in order to stimulate investment in the network.

The main idea, built into the tariff system, is that tariffs must cover not only operating expenses, but also provide a return on existing capital of 6% in 2010, 9% in 2011, and 12% in 2012. Under this standard, the return on new capital investment should be 12%.

Between 2006 and 2009 the average tariff for all distribution companies in MRSK-Holding rose from 35 kopek/kilowatt-hour to 67 kopek/kilowatt-hour – that is, more than 90%. The part of the tariffs covering operating expenses rose only 65%, while the part of the tariff covering investment almost tripled.  

The change in the structure of investment expenditure between 2007 and 2009 is shown in Table 1. The share of expenditure on “technical re-equipment and reconstruction” fell, while expenditure on “new construction and expansion of operations” increased.

 Table 1.    Structure of Capital Expenditure of МRSK-Holding in 2007-2009

    2007   2008   2009
Technical re-equipment and reconstruction   62.4%   58.8% 44.8%
New construction and expansion of operations 33.6% 37.2% 50.5%
“Objects” 4% 4% 4.7%

 

The investment program of MRSK-Holding during 2011-15 provides for further increase in the share of new construction within a general increase in capital expenditure. As seen in Table 2, the investment program for 2011-15 provides for an approximate doubling of all basic indicators.

Table 2.     Change in investment МRSК in 2010-2015 

  2010 2011-15 Average for 2011-15
Length of new power transmission lines (km) 12,196 113,332 22,666
New transformer capacity (MVA) 7,512 69,253 13,851
Investment program in millions of rubles (less VAT) 89,270 921,107 184,221

 

There is need for increased transparency and competition.

Procedures for choosing suppliers of equipment and contractors are not transparent. Although MRSK-Holding is practically owned by the state and the pricing of its services is not determined by the market, it is formally a commercial organization and not obliged to comply with Federal Law 94 “About placing orders for supply of goods, performing work, and rendering services for state and municipal needs”.

The result is probably a considerable over-payment for goods and services.

Another possible direction for lowering costs is reducing losses in the network. According to the 2009 accounts of MRSK-Holding, actual losses were 8.5%. The average for the EU is 6.1%.

There have already been some advances in this direction. The level of losses in the “MRSK Central and Volga” in 2010 has been reduced by 0.35% from the 2009 level, while distribution has increased by 6%. This has been achieved by way of a series of organizational and technical measures, and this experience could be useful for other companies that are part of MRSK-Holding.

In the medium term it is feasible to lower loads and losses on the network by introducing new technologies and management practices, including “smart grids” and “smart meters”.

Considerable cost savings could also be achieved in the personnel area. Reduced numbers of workers could be achieved through simpler organizational structures, re-training, modern IT systems and outsourcing.

They conclude that the main way to lower the rate of growth of tariffs may be introduction of full-scale competition “at those points where monopoly is not really a monopoly”. That is, in generation, local networks, and procurement.

Implementation of these measures would lead to leveling of the balance between producers and consumers, lower the load on the network, increase in the profitability of operating activity, and lower the needed investment which needs to be repaid with tariffs.

Thus, they say, changing the principle of tariff formation does not make sense. It is sufficient to engage in fine tuning.  

Railways: 

Dr. Arpolov reported on the present situation and directions for reform of Russia’s railway system:

Russian railways critically lag behind the world in terms or organization and technology in both passenger and cargo transport, and this adversely affects the whole Russian economy. Is a need to lower costs and increase the speed of delivery of both passengers and cargo.

Tariffs are being increased every year without any evident improvement in the quality of rail services. Self-financing railway transport is too costly for passengers and business.

He argues that there is a need for a specialized state structure to directly “manage infrastructure” maintenance and development. There is a need to strengthen state participation in development of rail transportation, and to change in the economic and financial relationship between the state and railway transport.

Main lever for providing efficient rail transport is centralized management. Is a need for better work practices to lower expenses, including labor intensive transport and repair work. is a need to increase use of container and other easily unloaded cargo systems.

He says that in the long-term railway transport must remain a “natural monopoly”, and the state must be responsible for its development; management needs to be improved, and the role of the Russian Ministry of Transport strengthened.

Gas:  

Prof. Ulanov of the Higher School of Economics:

Gasprom is involved in too many non-core activities, possible cross-subsidization of various activities, and is a lack of transparency. World best practice regarding monopolies could also suitably be applied in Russia.

Reform of Gasprom does not need to begin with privatization, but with financing an improvement in divisions and units, and removal of non-core assets and activities. Conditions of partial privatization must begin with increased transparency.

Gasprom continues to unjustifiably spend lots of money controlling a large part of Russia’s natural resources and economic potential. Gasprom can be reformed by removing those parts of it which can operate in a competitive market and regulating the remaining “natural monopoly” part.