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Russia's regional utilities own over 120,000 megawatts of combined heat and power (CHP) plants, more than the total capacity of either Germany or France. The current reform plan calls for the breakup of these into separate companies on a regional basis. The plan also calls for subsequent consolidation of these plants into large, interregional generating companies. Unfortunately, recent history has shown that this planned consolidation will not happen. Even breaking up the utilities is prohibitively difficult and there are far more parties opposed to consolidation. Industrial groups prefer bite-sized generating companies, or gencos, so that they can buy only what they need. Governors prefer small gencos because they are easier to control.
If reform stalls while power plants remain in small, regional companies then UES shareholders will have only two options -- both of them bad. Either retain these small gencos in a holding company, which will likely be run with the same efficiency as UES, or receive their proportional stake in a large number of small companies. While for strategic investors in UES receipt of stakes in a large number of small gencos could be interesting, for portfolio investors it spells disaster. Instead of one large, liquid investment, shareholders will receive tens or hundreds of small, illiquid companies. This results in total loss of value for portfolio shareholders of UES.
There is a better way. The regional utilities could create large, interregional gencos immediately. This does not require change to the UES reform plan, but it does require an addition. Prior to proportional breakup by business line, regional utilities would jointly create interregional gencos. Shares in these interregional gencos could be distributed proportionally to shareholders during restructuring as currently planned.
In addition to the CHP plants owned by regional utilities and discussed above, UES owns directly or indirectly a further 80,000 megawatts of federal power plants, which sell only electricity (as opposed to the CHPs, which sell heat also). These plants will be consolidated into wholesale generating companies. To clarify, all UES-owned generation will be formed into the "interregional gencos," which own CHP assets spun off from energos, and "wholesale gencos," which own federal plants.
Wholesale gencos will be distributed proportionally to UES shareholders. So far so good. But what happens if some shareholders -- i.e. the government -- decline their proportional stake in the wholesale gencos and choose to increase their stake in UES instead? Then UES acquires big stakes in the wholesale gencos on its own book and must decide how to dispose of these stakes.
The current plan is to auction off stakes in wholesale gencos in exchange for shares of UES. This is fair to shareholders of UES because their shares are used as currency to acquire assets that they own. However, very few potential buyers of stakes in the wholesale gencos currently own shares of UES. With few participants, auctions would be concluded at a low price and the end result would be acquisition of major assets for little money by Russia's oligarchs. What does this remind you of?
The government recently commented that sale of the wholesale gencos for shares might lead to a power oligopoly, as well as low sale prices. The proposed remedy is to open auctions to cash bids, thus increasing the number of participants. This is sensible except for a small catch: UES shareholders receive no benefit from sales for cash. On the board of UES, I twice proposed a mechanism for distribution to shareholders of proceeds from asset sales but was blocked. Cash received from asset sales would most likely be used for re-investment. However, every investment project undertaken by UES to date -- as far as I am aware -- has been inefficient.
How can we increase the number of participants in auctions for wholesale genco shares without allowing receipt of cash by UES? I have developed a simple proposal. UES writes a call option on its own shares to any potential buyer of wholesale genco shares. Thus participants may quantify their exposure in dollar terms. If they win the auction, they may buy the necessary shares at a fixed price. UES receives shares, rather than cash, thus retaining value for shareholders.
The options should be open to any participant in the auction whether Russian or foreign. UES should cover the options through purchase of its own shares financed by a loan from a major Russian bank (probably Sberbank). Because UES may set the exercise price wherever it wishes, it is likely to make a profit on the transaction.
Certainly, the simplest and best result is pure proportional distribution of shares in wholesale gencos to all shareholders. However, if the government insists on increasing its stake in UES through declining its stake in the wholesale gencos, we must fight any proposal to sell these stakes for cash.
UES shareholders must not delay in speaking up on these key issues in favor of: (i) the immediate joint creation of interregional gencos now, while we have momentum for reform; and (ii) the immediate denial of any sales of assets for cash, in order to retain fair value for shareholders. If the market were confident of these fair outcomes, UES shares would be worth more than 50 cents, rather than the approximately 30 cents at which they currently trade.
David Herne is chairman of the UES board committee for strategy and reform and managing director of Halcyon Advisors. He contributed this comment to The Moscow Times.