Energy efficiency: a new top priority

Context

Russia is one of the least energy efficient countries in the world. It uses three to five times the amount of energy to produce each unit of GDP compared with the EU member states and more than 20 times the amount of energy compared with Japan (the world’s most energy efficient country). Of the former East bloc countries, only Uzbekistan, Ukraine and Turkmenistan have worse records.

In its 2003 “Energy Strategy”, which covers the period up to 2020, the Russian government acknowledged the inadmissibility of this situation. It identified the potential for total energy savings during this period at 39-47 per cent of its overall consumption level for the year 2000. That equals 2.7-3.2 billion barrels of oil equivalent or 35-42 per cent of the total amount of oil and gas produced in Russia in 2007. According to the strategy, the bulk of these savings is to be achieved through the restructuring of the economy (to increase the role of light industry and services), while energy efficiency measures are to account for a smaller proportion of the savings, albeit one that is to grow incrementally during the period to 2020.

The impact of such energy inefficiency on the Russian economy is enormous. At the micro level, the competitiveness of individual companies is endangered, both on the domestic and foreign market. Traditionally, Russian industrial companies have enjoyed a strong competitive advantage over their Western counterparts because of heavily subsidised energy supplies (see below). But today, even with domestic energy prices still relatively low, it is not uncommon for a company’s energy costs to account for up to 50 per cent of total manufacturing costs.

At the macro level, inefficient energy use – not just in industry but also among residential end users – threatens the ability to sustain economic growth. Russia’s energy sector is already hard pressed to meet the increasing consumption that is accompanying the ongoing growth of GDP; and in 2008, peak electricity demand is expected to equal total generation capacity. In the gas sector, stagnating production raises concerns – flagged by the International Energy Agency, among others – about Russia’s ability to meet export commitments to European customers in the medium to long term. The traditional oil and gas regions are now past their production peaks, and there are immense challenges involved in the timely development of new gas fields. Against this background, the stopgap strategy of seeking supplies from former Soviet neighbours seems not only an expensive but also an inadequate expedient.

In part, Russia’s high energy consumption levels can be attributed to its harsh climate (the average annual temperature of virtually the whole of European Russia is below freezing and the average for most of Siberia is freezing or below) and to its energy intensive economy (almost two-thirds of total industrial output still comes from the most energy intensive sectors such as electricity generation, oil and gas extraction and refining and metallurgy). But it is energy inefficient technologies and infrastructure, as well as an extremely lax approach to energy use inherited from the Soviet era, that are mainly responsible for Russia’s dismal performance in energy efficiency.

The Soviet legacy

Outdated infrastructure and technologies …

Much of Russia’s infrastructure was already significantly outdated at the time of the demise of the Soviet Union. Its power generation and distribution networks continued to languish during the 1990s, and it is only now – through the unbundling of the holding company RAO Unified Energy Systems (UES), due to be completed in mid-2008 – that investment is at last being pumped into new generation capacity (using more energy efficient turbines) and transmission grids. UES has drawn up a US$250 billion restructuring plan aimed at both boosting capacity and significantly increasing energy efficiency; that plan, however, will not be implemented in full until 2020.

Russia’s district heating system, which still supplies most apartment buildings, is also a major squanderer of energy (despite the fact that almost 30 per cent of Russia’s heat is generated by combined heat and power, in itself a very efficient energy generation technology). In place since 1938, it is one of the oldest (and largest) of its kind in the world and is suffering from decades of neglect and underinvestment. Today, as much as 30 per cent of heat generated in Russia continues to be lost through transportation and distribution, largely owing to leakages from, and the poor insulation of, the extensive pipeline networks that carry heat directly to buildings.

A no less significant factor is the condition of those very buildings to which the heat is delivered. Most of the Russian population continues to live in apartment buildings that date back to the Soviet era, particularly outside cities with 1 million or more residents. More than half are in urgent need of renovation, and many have undergone no repairs whatsoever in 40-50 years. A similar state of disrepair is evident at many industrial premises throughout the country. This, combined with poor design and low-quality construction materials, results in enormous heat losses from buildings.

Still more energy is squandered through industrial production processes. As in the case of Russia’s infrastructure, much of the equipment and technologies being used by industry at the time of the Soviet Union’s collapse had already been superseded in Western industrial countries by more energy efficient equipment and technologies. Today, obsolete manufacturing equipment continues to be widespread: almost 40 per cent of production assets dates back to the post-World War II period, while over 50 per cent was installed more than 20 years ago. Similarly, around half of industrial companies’ energy equipment (boilers, ventilators, compressors and so forth) was installed before 1991.

The obsolescence of industrial equipment in Russia (in per cent)

Source: Federal State Statistics Service (Rosstat).

… and bad heating (and other) habits

Equally important, the attitude towards energy use engendered by the Soviet planned economy has been a major contributor to energy inefficiency in Russia. A key feature of that economy was the absence of incentives to save energy and/or minimise costs. Industrial enterprises received energy supplies at heavily subsidised prices in an era when supplies of oil and gas were still plentiful. As a result, hugely wasteful practices proliferated – one of the most egregious being the virtually routine flaring of associated gas (for our recent analysis of this subject, click here).

Among residential end users, too, wasteful practices became commonplace. During the Soviet era, a utilities payment system was put in place whereby households did not pay for consumption according to how much energy they had used; rather, they paid a fixed monthly sum based on the amount of living space, the number of registered inhabitants and the type of appliances installed (for example, stove and water heater). Thus there was little motivation to seal windows (particularly since the inability to control the level of heat delivered by district heating systems made it necessary to fling open windows on warmer days in winter) or turn off lights when leaving the apartment.

Higher tariffs are about to start biting

Throughout the post-Soviet period, end users have been able to carry on wasting energy with more or less economic impunity because energy supplies have remained relatively cheap. This has been especially the case for residential users. Under the (Soviet-era) system of cross subsidies, households have paid even less for energy than has industry – at the latter’s expense.

But that situation is about to change. Domestic gas prices are gradually being increased with the goal of reaching the same level of profitability as gas exports by 2011. The increase in prices for industrial consumers during the period 2007-2011 was forecast at around 2.5 times when the liberalisation decisions were first taken but is now set to be as high as three times, owing to the latest surge in the oil price and hence the European gas price. This has led the Ministry of Economic Development and Trade (MERT) to worry about the impact on overall growth and to propose – in April 2008 – extending the liberalisation timetable somewhat in order to shift some of the burden of this price adjustment from industrial to residential consumers. Under the original plan, household gas prices were to rise more slowly and remain regulated until 2015. MERT is now suggesting increasing the scale of residential tariff hikes in 2008-10 by about one-third.

But it is not only gas bills that will rapidly increase. Wholesale electricity prices are being deregulated incrementally: as of January 2011, all electricity produced in Russia will be traded freely – and hence its price determined by the market. Not least because gas-fired power plants account for around 57 per cent of electricity generated by UES (which itself produces more than 90 per cent of Russia’s total electricity output), electricity prices are likely to increase at a similar rate to those for gas.

End users’ response to the price signals

Industry leads the way with ‘good practices’…

Industry is already responding to the prospect of rising energy costs, which the government has been signalling since the deregulation of gas and electricity prices was first discussed in 2004. According to a 2006 survey conducted by the International Finance Corporation, almost 90 per cent of companies have begun taking measures to improve their energy efficiency. Most of these measures are low cost with quick returns, allowing smaller companies to finance energy efficiency projects without incurring borrowing costs. By far the most popular is the installation of meters: more than half of the companies surveyed had taken or were planning to take this measure. Other relatively inexpensive energy-saving measures (the so-called “good practices” in energy savings) being implemented include improving building insulation and switching to energy-saving light bulbs (where health and safety regulations allow their use) and automatic light controls (in communal spaces such as corridors and outside passages).

Upgrading manufacturing equipment and heating systems is the top priority of the bigger-spending companies; 50-75 per cent of industry’s total spending on energy saving is directed towards such projects. Many companies are still using boilers with a capacity that far exceeds their current needs. And many are keen to ensure independence from local utilities services by installing small-scale combined heat and power generators.

The other main high-cost measure is installing new compressors (which are among the most expensive uses of energy at any manufacturing plant). Specifically, mobile compressors are increasingly being deployed in Russia’s leading (and highly energy intensive) industries, such as metallurgy, where they can be used precisely when and where they are needed. Although compressors require a significant initial outlay, the pay-back period is estimated at no more than two years.

… while households lag behind

With energy price hikes for households staggered over the next seven years, it is not surprising to find that residential end users have been doing far less than companies to keep their energy bills down. Polls conducted by the independent public survey company Levada show that one year ago, 70 per cent of the population was making the effort to save electricity. However, only just over half of all households (55 per cent) were taking measures to save on heat during the winter months.

Unlike in the case of companies, there is a very low penetration of electricity and heat meters in households: estimates put the figure at below 15 per cent for both types of meter. In Soviet-era buildings, which continue to account for the bulk of living space in Russia, there are two main obstacles to a more widespread use of meters, apart from the current lack of economic incentives: the consent of at least two-thirds of households is required to install meters in an apartment building, and only a handful of district heating companies are geared towards a system of payments based on the regular reading of meters to determine the amount of energy consumed.

With power and heat prices still relatively low, households have not yet started clamouring for the means with which to self-monitor precise energy consumption. But the incremental – and, as noted above, possibly accelerated – price increases foreseen over the next couple of years point to a surge in demand for individual metering. In a parallel development, devices such as thermostat valves for radiators will acquire economic significance: currently, such devices are fitted for reasons of comfort (and as an alternative to opening windows) but do not result in money savings.

The government's approach

The legislative framework is weak …

With such a powerful driver as higher tariffs to propel energy savings, the government has been under no real pressure to take additional measures aimed at encouraging the population to save energy or discourage them from wasting it. In fact, it has admitted as much publicly. Last autumn, for example, Anatoly Yanovsky, the then director of the fuel and energy department at the Ministry of Industry and Energy, revealed that Russia was reducing the energy intensity of its economy faster than planned in its 2003 “Energy Strategy”.

Existing federal legislation on energy savings is largely a set of recommendations for which the implementation mechanisms are frequently lacking. For example, the 1996 law on energy savings was amended in 2003 to state that consumers who pay for energy savings measures themselves should receive lower tariffs for electricity and heating; the new amendment did not detail any mechanism or procedure for granting such reductions, however. Thus, as with much Russian legislation, this legal provision has remained a dead letter.

Other amendments to the energy savings law are currently being considered by the government. According to a senior Ministry of Industry and Energy official (speaking in late November 2007), one of the key planned changes is the creation of a state energy register that would systematically record the amount of energy used by companies, how effectively that energy is used and which energy-saving measures have been undertaken. The same official also stressed that the new version of the energy savings law would introduce energy use standards for all economic entities. However, given Moscow’s habitual bureaucratic foot dragging, a more effective legal framework for energy efficiency will be slow in coming.

… but building regulations have been tightened …

Meanwhile, there has been progress on creating a regulatory environment that promotes energy efficient construction. In 2003, the Russian government passed a new federal building code (“Thermal Performance of Buildings”), which was drawn up with Western assistance. In contrast to its predecessor, the new federal code applies not only to new and renovated buildings but also to existing structures. According to its authors, compliance with the new code results in the reduction of heat consumption by 35-45 per cent, depending on the type of building.

The introduction of the new building code has helped promote new building designs (for example, body width has increased from 12 metres to 22-25 metres) and technologies (including the Swiss-designed Plastbau). At the same time, new building materials and products have appeared on the Russian market. Monolithic frame construction, which has replaced single-layer and three-layer wall panel construction, requires external insulation and light thermal insulation. New light and porous concretes have been introduced, and windows with plastic or wood-composite frames and energy-saving glass have become widespread.

… and shortages are to be reckoned with

In reality, energy efficient construction, with its imperative of high-quality building materials, will be found only in the high-end segment of the Russian construction industry (for example, so-called A and B class office space – there is little distinction between these two categories – or the elite apartments and gated communities that are now a common feature in Moscow and, increasingly, in other cities with a population of at least 1 million residents). But that still leaves a huge market for the makers of high-quality building materials – as well as of advanced metering systems. As the charts below show, the construction of quality office space, retail and entertainment property, warehouses and hotels in Moscow has been growing apace during this decade and is forecast to continue to increase steadily in the medium to long term.

Similarly, in the residential market, there is considerable demand for high-quality construction materials – as a result, not least, of Russia’s burgeoning urban middle classes moving out of Soviet-era housing and into more desirable and spacious accommodation. While social-standard housing – or what is known as “affordable housing” in Russia under the national project over which President-elect Dmitry Medvedev has presided for the last several years (for more details, see our survey of the construction materials industry) – accounted for the largest share of new-build floor area nationwide in 2006 (just over one-third or 17 million square meters), high-end housing came in second place, notching up a noteworthy one-quarter share or 13 million square metres. In all likelihood, that share began to tail off in 2007, when new housing construction accelerated again to 60.4 million square metres, and will continue to do so as the “affordable housing” national project gathers steam and the initial rush to upgrade to higher-quality accommodation subsides. But high-end homebuilding will nonetheless continue to account for a sizeable portion of overall new-build floor area in the foreseeable future.

Russia’s construction frenzy will squeeze supplies of all types of construction materials and products, but it is likely to hit hardest where their manufacture is relatively new to Russia – namely, the high-quality construction materials and products that are used to achieve energy efficient construction. These include light insulation materials. In 2005 Russia produced around 8 million cubic metres of stone wool and 3 million cubic metres of glass wool; however, an estimated 15-16 million cubic metres of these materials are required by the Russian construction industry. Thus even in this early stage of what is sure to be a sustained surge in demand for energy efficient materials, domestic capacity is unable to satisfy demand for at least some energy-efficient products.

Trusted Judgement

Demand for more sophisticated metering is set to expand rapidly

Maxim Makarov, business development manager at a leading manufacturer of meters and automated meter reading systems

Not only is the penetration of metering very low in Russia; the vast majority of meters in use are old-fashioned induction meters. While electronic meters came into use in the West in the 1970s, it was not until the early 1990s that the serial production of such meters began in Russia. So with regard to the process of upgrading metering equipment, Russia is trailing the West by more than 20 years.

During the Soviet era the precise measurement of energy use was a very low priority owing to cheap (and abundant) supplies. But today the on-going liberalisation of electricity prices is resulting in new demand for more precise metering. There is also demand for tariff meters – which are a relatively new phenomenon on the Russian market.

Over the past 15 years or so Russia’s electricity metering market has developed from the top down, so to speak. It can be roughly divided into three levels: on the top level are the power stations, which were the first to switch to electronic metering; then there are the power distributors; and on the bottom level are the end users – industry (particularly the energy intensive sectors such as oil and gas extraction and metal processing) and households. While at the present time there are no real signs of dissatisfaction among households with the level of precision afforded by induction meters, that situation can be expected to change when households start to receive larger bills for energy use.

Today, an important feature of the Russian metering market is that energy generation companies do not have reliable data about the energy consumption needs of households and small non-industrial businesses, such as shops and kiosks. According to various estimates, the increasing use of domestic electronic appliances – an effect of real income growth – means that household energy needs are set to rise 10-20 per cent above present consumption levels. As the share of household and small business consumption in total energy use grows, energy generation and distribution companies will become increasingly interested in more sophisticated methods of assessing future electricity demand growth. This requires the use of advanced integrated systems – so-called automated metering reading (AMR) systems – which provide not only for the automated gathering of energy consumption data but also for the analysis of consumption trends.

Those companies that have already supplied generators and distributors of electricity with AMR systems are now in a position to expedite the next, logical stage in the development of the Russian metering market – namely, the installation of electronic meters not only in industry but also in households and small businesses. The logical follow-on from a business development point of view is to expand aggressively into the end-user segment of the market, which is currently dominated by small companies that focus on individual products (software or meters) rather than integrated systems.

Advanced energy-savings technology is increasingly being used in high-rise construction

Vice president of a leading Russian construction company

By far the most prominent – unavoidable, even – symbol of energy efficient construction in Russia today is the new tower blocks built to advanced modern standards. The Federation Tower now under construction in Moscow, designed as the tallest building in Europe, is a prime example of such construction. It uses a state-of-the-art heat recuperation system that is capable of recovering up to 60 per cent of total heat consumption. This alone translates into savings worth millions of dollars a year.

Other savings measures that are being used in these largely steel and glass buildings are windows that are able to reflect sunlight and at the same time prevent heat from escaping. Automated systems that allow surplus heat to be pumped from one part of the building to another will become an ever-more common feature. And a less costly, but hugely important energy savings measure is the installation of sensors that pick up changes in fundamental parameters – such as temperature, level of lighting and number of people present – and regulates heat and power consumption accordingly.

Wrap

The price driver

Energy efficiency is set to be an ever more compelling investment theme in Russia for the simple reason that it has a powerful and durable driver.

If regulation were the main factor, the picture would be less exciting – since enforcement is always weak in Russia owing to bureaucratic inefficiency and corruption. As for Russia’s attitude towards climate change catching up with Europe and North America, a good proxy for this catch-up is per capita GDP. So this issue will remain a minority interest in Russia for another couple of decades (especially since many Russians see their country as a beneficiary of global warming).

Instead, investment in energy efficiency will grow more rapidly than overall investment demand simply as a result of the process of gas and electricity price liberalisation, the various stages of which are due for completion in the 2011-15 period. Price signals, of course, drive energy efficiency investment the world over; but the impact of energy price liberalisation in a former centrally-planned economy is immeasurably greater than that of marginal fuel price changes in a developed market economy where rational allocation of resources has long been the norm.

For 15 years after the Soviet collapse, the Russian economy continued to enjoy cheap energy, at the expense of Gazprom and UES. The government’s cardinal decisions in November 2006 to phase out regulated energy prices stemmed from the realisation that, as the experience of shopping for staple goods in the late Soviet era demonstrated so powerfully, keeping the price of goods artificially low for long enough will result in those goods ceasing to be supplied. From this perspective, the investment theme of energy efficiency emerges as a side effect of the imperative to ensure that Russia will be producing enough gas and electricity in the first place.

But however long it takes the share prices of Gazprom and the generation companies spun out of UES to reach a level that properly discounts returns on invested capital in liberalised energy markets, it will be longer still before demand for energy efficiency stops growing. This is not only a buoyant long-term prospect. Energy efficiency is a live investment theme here and now as the related demand takes off from a low – and sometimes non-existent – base.

Three plays

As compelling as this conclusion may be, this is the simple part. Finding plays on demand for energy efficiency will be more complicated than buying stock in Gazprom or a basket of OGKs/TGKs.

1. Industry

The main difficulty lies in the sheer variety of forms that this demand will take across virtually all industrial sectors. But it is safe to say that analysis of any sector, and even of individual companies, will now do well to pay specific attention to energy efficiency angles. This is all the more true as the sharp hikes in electricity prices shorten the payback periods on investments in energy efficiency, underpinning investment demand in this area.

By way of example, an interesting project that we have come across is in the industrial gases sector. This involves supplying modern gas compressors to all sorts of manufacturers, with payment in the form of a share of the savings that the customers make relative to what they would have paid for electricity had they continued using their existing compressors.

2. Construction materials

Demand for energy-efficient construction materials is concentrated in the high-end segment of the surging construction sector. Our second trusted source offers vivid insight into the extent of such demand. Even if that segment’s share in total construction is falling (from a high base – and remaining large in absolute terms), energy efficiency will become increasingly important in mass housing construction. Regulation would in any case help at the margin here. But this “trickle-down” effect of energy efficiency demand will be enhanced more directly by fast increasing government investment – notably through the new Rb250 billion Housing & Communal Services Fund – which will tend to promote compliance with the federal building code.

It follows that within the already flourishing construction materials sector, companies with an edge in energy efficient materials – such as advanced glass and concrete plus all types of insulation – should see the fastest growth. Some of the best examples listed in the “Relevant Companies” section of this report are Russian subsidiaries of foreign-owned groups. But pure Russian companies will catch up; for example, LSR – one of the sector leaders – is actively building and buying porous cement capacity.

3. Metering

In a field where straightforward and across-the-board investment plays are hard to come by, the one pleasing exception is advanced metering. As energy prices rise, demand for more accurate meters will be a universal precursor to a wide variety of spending decisions related to energy efficiency. And as our first trusted source explains, the demand for advanced metering comes from both energy suppliers and consumers. Among the latter, households will feature ever more strongly in coming years since, in percentage terms, it is households that face by far the biggest increases in energy costs. Moreover, as mentioned in the “Context” section above, the pace of those increases may now be accelerated.

The example of the more advanced Central European transition countries suggests that automatic metering networks will expand rapidly – not only within the core electricity sector but also in other sectors such as water (Slovenia offering a case in point). The Russian metering market will be a major opportunity for all companies involved – whether equipment manufacturers, technology suppliers and distributors or operational service providers.

Relevant Companies

Energy efficiency

Name	Description
Pobeda Knauf	A subsidiary of the privately owned Knauf Group, Pobeda Knauf produces high-quality construction materials. Based in St Petersburg, it is the market leader in wall bricks in northwestern Russia. The company also produces ceramic insulation bricks.
Rockwool Russia	Based near Moscow, Rockwool Russia is a subsidiary of Rockwool International AS (ROCKA DC). It produces stone-wool insulation materials, among other products.
Bor Glassworks (BORG RU)	The company is majority-owned by Glaverbel SA, which is Europe's leading producer of flat glass, including state-of-the-art energy-saving products. Based in the Nizhny Novgorod region, Bor produces 1,100 tonnes of glass per day.
LSR Group (LSRG RU)	The St Petersburg-based company develops and constructs large-panel and high-end housing. It also produces building materials and develops property.
Inteko	Owned by Elena Baturina, the wife of Moscow Mayor Yury Luzhkov, Inteko is involved in construction, the building materials industry and the management of commercial real estate.
MIRAX	MIRAX constructs monolithic high rises mainly in Moscow and St Petersburg. It is the official developer of the Federation Tower, designed as Europe's tallest building, which is being constructed in the new development "Moscow-City".
SU-155	The closed joint-stock company builds residential housing mainly in Moscow and the Moscow region.
PIK (PIKK RU)	PIK builds mass-market residential housing and also maintains the housing developed both by itself and other companies. It operates mainly in the Moscow region.
Elster Metronika	A subsidiary of the UK-based private company Elster Metering, Elster Metronika manufactures and supplies mainly electronic electricity meters and advance meter reading systems in Russia and the former Soviet Union.
Echelon (ELON US)	The company produces software and hardware for various metering applications.