Anticipated Result Of Energy Sector Privatization

Recently the Government and the State Property Fund have issued frequent public statements regarding privatization of power industry assets. This gives reason to believe large-scale privatization is to return to Ukraine within months. In a rush for new revenue sources for the State budget instead of reforming the energy sector itself, officials are busily talking up reforms.

Assets subject to privatization

The first sales of power industry assets occurred at the end of 1990s, followed by partially successful privatization of Yuschenko’s Government in 2001. The State currently owns 19 blocks of shares. Thermo-generation assets, which produce up to 40% of all power: Dniproenergo – 50% plus 1 share; Donbasenergo – 85,77%; Tsentrenergo – 78,28% and Zakhidenergo – 70,1%, are reasonably considered to be the premium ones. The other fifteen assets are distribution network operators, a link between consumers and producers of power, at the same time being their sellers. The state blocks of shares in the distribution companies exceed 50% in general, apart from Cherkasyoblenergo – 46%.

Due to the lack of state funding and numerous factors connected with improper payments for power, electric power enterprises traditionally remain in great necessity of funds to modernize their fixed assets. Experts estimate these fixed assets to be often degraded by up to 80% in thermo-power companies and 60% in distribution companies. These companies are therefore in a chronically degraded condition, according to international standards. This is noticeable in low effectiveness of production and distribution of energy (consumption of energy resources in generation exceeds 35 %, while expenditure level of power distribution is twice higher than in the developed countries). Only the attraction of some big power players to the market, with their experience, as well as technological, and financial capabilities, is able to resolve these problems.

Prospects of power market are equally pessimistic. The wholesale power market functions as an outdated model of “a single buyer”. Ineffective and inefficient formation of price and tariffs (unreasonable rates on power production and distribution), as well as the practice of cross-subsidization, reduce such incentives as increasing power efficiency for the benefit of consumers and producers of electric power.

Despite all these problems, electric power enterprises are blue chip and still remain quite attractive for privatization. All the enterprises are monopolies in a country with a population of 45 million people and an impressive industrial sector. These circumstances are still not enough to attract large, international investors, however.

Investment climate

Another no less important issue that should be taken into consideration is the investment climate in Ukraine or rather its adversity. The attempted sale of energy assets without changing in the rules of the game in electric power sector would be a mistake. All the previous attempts of the state authorities to implement any transformations have failed. Following the presidential election, the authorities announced an extensive reform of the national economy, particularly of the energy industry.

When analyzing the main points of the planned reforms, it becomes quite evident that transition to a free market is at the core of such transformation. Real independence of a regulator (National Electricity Regulatory Commission of Ukraine) will be guaranteed, administrative intervention in the market performance will be minimized, mechanisms ensuring market pricing for electricity will be impelemented, “a single buyer” model will be rejected and the market will become open to direct agreements with large industrial consumers. There will be new basic laws such as “On state Regulation in Electric Power Sector of Ukraine”, “On Electric Power Sector”, “On Natural Monopolies”, “On Frames of Performance of Electric Power Market in Ukraine”. Dozens of Resolutions and Instructions of the Government and Acts of the National Electricity Regulatory Commission are subject to cancellation or amendments.

The full implementation of these reforms will make the sector far more attractive for investors. According to the plans of Ukrainian authorities (visit the website of the President of Ukraine on “The Committee on Economical Reforms”) the reforms will be implemented by the end of 2014, while privatization of all electric power industry assets is expected to be finished by the end of 2012. Or so the authorities allege. However, according to the frequent recent statements of high-level officials regarding the preparation of the electric power assets for privatization, the terms of sales will be shortened significantly. Does this mean privatization will begin without any qualitative shifts in the electric power market? If that is the case, many specialized investors will ignore the tenders.

Let’s imagine the tenders were announced. The first thing foreign investors would pay attention to would be their negative experience of privatizations in Ukraine. Let’s analyze what has happened regarding the largest tenders during the last three years.

Privatization of JSC “Holding company “Luganskteplovoz” was conducted for a third time this summer, but yet again the enterprise may be returned to the State. The Russian investor, who has bought the enterprise twice, still does not own the block of shares despite USD 63 million transferred to the State. The Government does not hurry to return the money at all. The reasons are always ready – Ukrainian laws protect state interests exclusively. Does anybody want to participate in Ukrainian privatization?

The tender for sale of a controlling block of shares of JSC “Odessa Port Plant” was also held three times. The last attempt concluded with an unprecedented privatization scandal for Ukraine. Dissension between the Government, the State Property Fund and the President concerning privatization of the enterprise created an absurd situation: the question of privatization was considered by the Constitutional Court of Ukraine. The only western investor who took part in the tender (Yara Company, Norway), immediately rejected the outcome of the tender. A court injunction for one of the main participants – Russian company “Sibur-Minudobreniya” arose. As a result, according to the expert opinion, the State received a low sale price. The Government had not to admit the results of the tender. Finally, due to the Government instructions, the tender guarantees of two participants were transferred to the State budget. The two guarantees amounted to about USD 100 million and had not been returned for a year. Does anybody want to participate in Ukrainian privatization?

Recently information appeared in press, the hearing of the claim brought by the General Prosecutor’s Office in the Cabinet of Ministers interests has started. The claimant asked to invalidate supplementary agreements to the purchase-sale contract of block of shares of metallurgical complex “Kryvorigstal”. The defendant is an international company “ArcelorMittal”. If the trial continues and ends in favour of the General Prosecutor’s Office, the state will have an opportunity to terminate the purchase-sale contract of lagest enterprise in Ukraine.

Ukraine, more than ever, is a very risky prospect for foreign investors. International investors have quite limited possibilities to protect their interests in courts and elsewhere.

Privatization procedure

Such haste is understandable: the names of assets to be the first ones in line for privatization and the approximate time limits for tenders to be started are already available online; however, at the moment nobody can say under which laws and procedures such assets will be sold. At the present time, basic legislation on privatization is subject to revision and draft laws will reach the parliament only at the beginning of November 2010. Even if tenders started only after the new privatization laws had come into force, these would be the first sales with no time for trial runs.

Analysis of the draft laws “On State Privatization Program”, “On amendments to some laws of Ukraine regarding privatization”, as well as the provisions of the Program of economical reforms of privatization and state property management, are our next consideration.

Electric power assets will be sold with the help of expert advisors. This is a quite logical – such assets shall not be sold without such support. However, it’s still unknown how much these advisors are Government and the State Property Fund oriented. Will the advisers be from large foreign investment banks or national consulting companies, only time will show. This year there is no way to choose an advisor: the State budget for 2010 provides the only expenses for an adviser to assist the JSC Ukrtelekom sale.

There are no special regulations specifying tender sale of electric power industry enterprises. That means the tender will be held according to the “Regulations on tenders on sale of block of shares of joint-stock companies of 31 August 2004 № 1800”, which almost completely excludes case-by-case privatization. These Regulations act as a conveyer and may be used in sales of any kind of joint-stock company. For instance, such an important element of any case by case transaction as negotiations between seller and buyer are not used sufficiently, as if there is nothing to nigotiate.
Another problem is the quality of fixed tender conditions, which afterwards are transferred to a purchase-sale contract as buyer’s investment obligations. During the last five years the list of the fixed conditions has been inceased extremely. Investors can face absurd obligations that are surely impossible to perform. Some conditions often contradict legislation. Generally such conditions are not an obstacle for Ukrainian investors as already at the preparation stage they decide which obligations will be performed or possibly canceled through the courts. Thus, national and foreign investors do not have equal rights. Foreign investors in such circumstances should factor the additional risk into the price they are prepared to pay.

Forecasts

It is clear there will be no reforms before privatization starts. If the planned laws are nevertheless adopted within the next two years, there won’t be any significant results or impact because the laws may still be not enforced properly. In such circumstances energy sector privatization will attract only a limited number of investors.

Three types of investors traditionally participate in privatization of Ukrainian blue chips: western, Russian and Ukrainian. Western investors are worse affected by the conditions, under which privatization is attempted in Ukraine. Their participation in tenders is unlikely. In contrast, the probability of Russian participation is quite high. Some energy market experts estimate that the Russian companies’ interest is based on geopolitics sooner rather than on economics. Their main competitors are well-known national financial-industrial groups, who have targeted certain assets for a long time. Competition between such groups is unlikely. Ukrainian companies have an undeniable advantage – they are on their home turf. There are many reasons to expect the energy enterprises will remain in the hands of Ukrainian owners.


Andriy Pidhayny
AGRECA partner

november, 2010