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Interview

with Jack Neushloss, Head of the Electric Power Sector, SKOLKOVO Business School Energy Centre (SEneC)

27.11.2012 / Energyboardroom

Mr Neushloss, prior to joining the SKOLKOVO Business School Energy Centre’s team you spent decades working in Poland, Hungary, Canada, Mexico, South Africa and Central Asia. What surprises you most about the Russian power market?

After many years with a large utility company I started working for a British law firm—CMS Cameron McKenna, one of the few that have been deeply involved consulting the power industry all over the world since the early nineties. The firm hired me as a former utilities executive to serve as a link between industry and legal professionals. Starting with the restructuring and privatisation of the power sector in England and Wales the firm has been significantly involved in the restructuring of the power sector all over the world, in many different jurisdictions.

What was unique in Russia – as opposed to other jurisdictions where I have operated – is that the initiative to reform the industry did not come from the government but from the management board of RAO UES – the electricity monopoly at the time– itself. As far as I am aware, this has been the only case in the world where such initiative did not come from the government.

For many reasons, governments and international agencies such as the World Bank or the International Monetary Fund (IMF) review the functioning of the power sector, a move many utility companies generally oppose. In Russia, however, it was exactly the opposite, where the Chairman of the Management Board of RAO became the main driver of the reform.

You had been advising former RAO UES on a wide range of issues relating to the Russian electricity market reform, including market model, market rules, contractual structure and regulatory regime. What is your view on the outcome?

As usual, some things have succeeded and some have not. What definitely succeeded is the structural change—splitting the company into generation, transmission, distribution and supply. The market that has been created is suboptimal, yet shows all the features of a competitive market. From an historical perspective, the entire reform can definitely be considered as a major success.

At the XII International Scientific-Practical conference held on 15-20 May 2012 in Barcelona, you stated that “the structure of the electric power sector is not adapted for the integration of small size generation”. Can you explain this statement further?

There are many factors which hamper the development of distributed generation. One of the major factors is the issue of cross subsidisation—customers who build their own power stations stop buying power from the grid or at least significantly reduce such purchases. As a result, the revenues of distribution companies and centralized generating companies drop and thus contributions to cross-subsidisation diminish.

The reasons why certain consumers are moving in the direction of distributed generation are not difficult to find out. Tariffs – specifically in distribution – have grown in the last several years quite significantly, affecting profits of customers and creating an unpredictable future. Changes in legislation are also frequent, adding on to this level of uncertainty.

Moreover, any change in capacity required from the grid by a customer usually results in additional payments of connection fees, which can be quite sizeable. Generating one’s own power therefore provides better flexibility due to a lesser dependency on the grid companies.

Another incentive for consumers to generate their own power is the frequent power interruptions caused by atmospheric disturbances such as floods, ice rain, high winds, etc. For shopping centres, manufacturers, data storage centers and the likes, the switch to own generation close by enhances security of supply.

In addition, there is even some movement on the residential side too, with home owners now installing micro turbines. Once again, the underlying motivation is security of supply and difficulties in obtaining a grid connection.

In my opinion, in order to increase security of supply it would be necessary to review the standards of design and construction of grid assets and facilitate development of distributed generation.

According to the State Duma Energy Committee, electricity tariffs have increased drastically in Russia ever since the reform: 12 times. From a consumer perspective, what do you see as an acceptable growth rate in tariffs for the coming years? Should they be worried?

No consumer likes tariff increases, so the question from a consumer’s point of view is actually self-evident. If one goes a bit deeper in analysing what the real reason for these tariff increases, however, the conclusion will be that market prices for energy so far are tolerable.

Generating companies raise concerns about the cost of fuel and decreasing profits. Here competition more or less works. Prices for transmission –and specifically distribution on the other had – have been skyrocketing. Bear in mind that all tariffs for using the grid are state regulated. The transmission tariffs, for instance, are regulated by the Moscow-based Federal Tariff Service. Distribution tariffs of the local distribution companies are in turn regulated at a regional level.

Experts ascribe the growth of grid tariffs to a number of reasons. Some claim that the primary reason behind the growth is a change in the methodology to calculate the allowed revenue for these companies. The government has changed its “Cost Plus” system to the so-called “Regulated Asset Base (RAB)” system; an American terminology. This change was one of the reasons for tariff growth. Other reasons are also mentioned.

The situation reached a stage where in certain regions prices for transmission and distributions started to exceed those for generation, which is absolutely wrong.

Experts from the sector have claimed that although new power plants are far more efficient than Russia’s older plants, it remains cheaper to run the older plants than to invest in new power plants. Do you agree with this statement?

What is indeed true is that all of the “old” plants have been built during the Soviet era. Calculating the exact costs of their construction remains impossible, which evidently influences how one calculates annual depreciation. Overall, older power plants—considering fixed and variable costs combined — are probably cheaper to run than the new ones. The older plants require a fair amount of maintenance however, and face diminishing efficiency over time.

The Russian energy strategy forecasts a need for 577-888 billion dollars of capital investments in the period to 2030 to expand and modernize the system. Is this a realistic target set by the government?

To provide investors with some sort of guarantees with regards to new investments, the so-called Capacity Provision Agreements were put in place. Today, these contracts guarantee capacity payments to the plant owner for 10 years whether the plant operates or not. There are more than 100 of that sort of agreements in Russia.

Obviously, there is a fair amount of negotiation in terms of how much will be paid for capacity through these agreements which are drafted to enforce the commitment of the investor to comission the power station in question to a specified date. As far as I know, all the foreign investors stood by their commitments. Some Russian companies, however, did not. There have been talks about delays regarding commissioning dates of the plants and even about terminating contracts.

As a last personal question, we understand that you have joined the SKOLKOVO Energy Centre’s team as the Head of the Electric Power Sector in March this year. What do you aim wish to contribute?

The Centre has one very significant advantage that is recognized by many: complete independence. The Moscowe School of Management is a private institution, sustained by student fees and contributions. We are even handed towards generators, distributors, supply companies and consumers. In doing our research or consulting we are guided by the laws of economics. And a bit of common sense.

Myself, I try to promote what I believe is right, which is what I see as my contribution. That means analytical work, to an extent advice to industry participants and potential advice to the Ministry of Energy. What I eventually want to achieve is to participate in the education process of the SKOLKOVO Business School, by generating an interest in the power sector among its executives and MBA students. There is always a future in the power industry.

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