Soviet central planning created a herd of industrial monsters, which formed the backbone of Russian industry. However, as communism's hold over the market gave way to Russia's unique brand of capitalism, it became clear that these monsters would have to adapt.

Ten years later, and the so-called "natural monopolies," such as Unified Energy Systems (UES) and Gazprom, strangely live on, almost as they were before – the last of the Soviet era dinosaurs.

Although they do remain regulated, it is not because they ought to be regulated. Rather, it is because the state is capable of leveraging its power over them, and so it does.

In Russia, regulation does not mean protecting consumers from unreasonably high prices. Instead, it means forcing power suppliers to subsidize the industry and consumers. This makes a monopoly in Russia quite different from a monopoly in the West. Here, monopolies don't use their privileged status to command high prices; they are forced to charge low ones.

The electricity utilities are calling for the deregulation of Russian power generation and the introduction of competition into the heavily regulated sector. Competition, they expect, will turn around their highly inefficient and irrationally managed industry, which will in turn, save taxpayers billions of dollars a year.

At the same time, competition will lead to a huge value redistribution. It is estimated that utilities are giving up around $8 billion to $10 billion annually in subsides to the economy. The reform is not a zero sum game. The cost-plus tariff setting system provides an incentive to inflate cost while artificially low natural gas prices do not provide an incentive to upgrade power plants.

Modern combined-cycle power plants consume 240 g of fuel equivalent per KWth vs. the current Russian average of 345 g per KWth. Annually, Russian power plants burn 135 billion cubic meters of natural gas per year, 30 percent of which is worth more than 4 billion dollars annually at export prices and could be saved if Russian power plants were upgraded.

Another $1 billion to $3 billion a year could be saved by optimizing cost structure, preventing unauthorized usage of electricity and decreasing leakage in the power grid. In a competitive environment, market forces should determine how this extra value is going to be redistributed. The value at stake is huge. Below is an analysis of what the future structure of the industry could be and who the major players might be.

According to the reform plan, the industry after the restructuring should look as follows:

• Five to seven "wholesale gencos" formed out of large condensing stations owned by UES and large (with more than 500 MW of installed capacity) conducting stations owned by regional energos. According to our estimates, there are around 25 qualifying stations with a total installed capacity of 43,000-44,000 MW (or 20 percent of Russia's total generation).

• "Community gencos," which at least for the first stage of the reform, would be subsidiaries of reformed regional energos. These companies would own co-generation stations and would be considered heat producers with electrification being the byproduct.

• One or two nuclear power gencos.

• At least two hydropower gencos.

• The lost co-generation. We expect the community of gencos (or regional energos) to start losing market share to wholesale gencos at the first stage of the reform, since the reform is going to become a big challenge for the Soviet-era system of centralized heating. Co-generation stations look efficient when there is sufficient and stable demand for heat.

However, when demand for heat is low, their efficiency drops below any reasonable measure. According to our estimates, at least 20-25 percent of all electricity produced by regional energos is being produced in this inefficient way.

Currently, large industrial users have constrained access to the wholesale market, largely due to regional protectionism. Now UES management is interested in demonstrating that the non-vertically integrated power companies are efficient.

The co-generators are likely to maintain a stronger position in the residential market; however, their strength here would also be based on hidden subsidies from regional governors. The bulk of the cost associated with central-heating costs (such as repairs of the heating system digging up streets etc.) are currently are now being paid by municipalities i.e., by taxpayers.

I do not expect the market share of nuclear plants to increase considerably. Nuclear power is not as cheap as is believed in Russia. Also, the nuclear industry is going to remain state-owned.

The liberal reforms are going to decrease the amount of funds redistributed through the state budget leaving few chances for the Nuclear Energy Ministry to carry out its Napoleon-style plans of more than doubling nuclear capacity in the next 10-15 years. I do not expect a "Russian EDF" to emerge, because such a scenario would require a figure equal to Berezovsky, Chubais and Vyakhirev combined to take charge of the ministry.

In the course of reforms, I expect traditional utilities will lose market share to the following groups of competitors: Onsite co-generation; distributed generation; new entrants (producers of natural gas).

Co-generation-X. Onsite generation is most likely to be set up by large industrial companies, primarily large producers of heat.

• Petrochemical companies and oil refineries that are large users of heat and also have both fuel and capital are the first candidates to set up their own generation.

Paper mills currently own large capacities, around 1,800 MW utilization rates for these stations is rather low (30-35 percent). Onsite heat-production levels suggest that paper mills could co-generate 4-5 times more electricity than they produce today.

Distributed generation: In recent years, due to technological changes, the optimal size of a power plant has decreased to 150-450 MW from 1,000 MW and has a tendency to decrease further. In the modern world, flexibility is priced much higher than size. The future way of producing electricity is considered to be a distributed network of small generators.

New entrants: Oil and gas companies are likely to become active players in the sector for two reasons. First, they have the fuel (natural gas); second, they have the money.

With Rem Viachirev out of office at Gazprom, oil companies are likely to gain access to the gas pipeline. UES reform should allow non-discriminatory access to the grid. Therefore, the oil companies should be able to build new stations where there is high demand for electricity and supply them with their own natural gas.

Currently, oil companies produce 29 billion cubic meters of gas annually, of which 5 billion is being burned up. Only Surgutneftegas is currently supplying a relatively high amount (10 billion cubic meters) to power stations (such as Tyumenenergo). The company also plans to cover up to 20 percent of its needs in electricity by installing gas turbine generators fueled by associated gas on their new oil fields.

With the gas-pipeline deregulation in place, oil companies expect to produce up to 150-200 billion cubic meters of gas per year – enough to meet all Russia's demand for electricity. Oil companies will have a choice. Either they can supply gas to existing power stations, or they can build their own capacity. The decision depends on the oil company's management strategy.

Surgutneftegas, for example, so far follows a rather conservative strategy, focusing primarily on oil production. Meanwhile, other companies such as Yukos and LUKoil have diversified their business. Yukos already has a plan to develop power generation and to build (or buy and modernize) power stations with a total capacity of 1,000-2,000 MW.

The Gazprom reform may also lead to the appearance of "baby-Gazproms," or other gas-producing structures that may be interested in vertically integrating into power generation.

Conclusions

While the reform is going to create huge value for the industry, it will force the "old" utilities to fight hard for their piece of the pie. We expect competition in the industrial segment of the market to heat up three to seven years from now, as new entrants start gaining market share while large and solvent producers start to create onsite generation.

The period of time that gencos have to prepare for this competition depends on two factors: interest rates and domestic gas prices. High interest rates (or a high cost of capital) would deter new entrants. Capital costs represent a major share of electricity tariffs.

Since wholesale gencos currently have substantial excess capacity, the marginal costs of producing electricity on the existing power stations are low enough to deter new entrants as long as natural-gas prices remain low in Russia.

The higher the natural-gas prices get, the bigger advantage new entrants get because they would need to burn 30-50 percent less gas to produce 1 KW, compared with the existing power stations. At a $50-$60 per 1,000 cubic meters of gas and 6 percent interest rate, capital charges are equal to the cost advantage due to lower gas consumption.

(The author is an oil analyst at the NIKoil investment firm. )