This week Russia’s Economic Development Ministry and the local authorities on the Far East island of Sakhalin have proposed imposing fines of RUB150-2,000 ($2-25) per tonne on companies that exceed proposed new greenhouse gas (GHG) emissions quotas.

The hydrocarbon-rich island is home to major gas deposits and also the country’s first LNG plant. The fines are part of a push by the Kremlin to start dealing with the climate crisis and meeting its commitments under the Paris Accord that was ratified in 2019.  

Russia has been criticised for going slow on tackling its GHG emissions, but that has started to change rapidly, first of all driven by the leading corporates, but now the government is getting into the game.  

The proposed rules form part of a draft law on GHG emissions in the Far Eastern region now up for approval by the government in Moscow and represent a first pass at the thorny problem of setting a price for carbon emissions.  

A string of massive environmental disasters in 2020 and the increasing awareness that Russia’s permafrost is melting have put the climate crisis on Russia’s policy agenda and the Kremlin is responding. In recent months, the public discussion on stricter environmental disclosure requirements risks has picked up pace and the state is getting ready to legislate.

At the same time, the growing call by the general public for sustainable, as well as profitable, investments and bans on holding the equity of “dirty” companies that have poor environmental, social and governance (ESG) scores have forced some of Russia’s household names to launch in-house sustainability strategies and invest billions of dollars on clean-ups that add nothing to their bottom line.  

And the risks of doing nothing are rising. This week investment bank VTB Capital (VTBC) argued in a note that Russia has already passed “peak oil” in 2019 as ESG concerns will prevent a ramp-up to previous levels of production once the coronacrisis fades completely. Russia produced an all-time high of 11.4mn barrels per day (bpd) in December 2018, but since the oil prices slumped in 2014 it has joined the OPEC+ deal to limit production and hold up prices. Oil production fell to a low of 9.2mn bpd in June last year and has since recovered to 10.2mn bpd, but some analysts say it will not rise much further. The OPEC+ deal is due to expire again soon as post-crisis demand returns, but VTBC analysts argue that even when the fetters are thrown off Russia’s production will continue to slide as the world increasingly turns to alternative sources of energy.

But the sword that may skewer Russia’s energy business is the EU’s new Green Deal that promises to make the trade club carbon neutral by 2050. Part of this programme is to introduce a carbon tax on “dirty” goods producers – companies’ with high CO2 emissions or just poor ESG scores.

Now the government is starting to take some action. Last year the state introduce a national strategy to deal with emissions and in January this year Deputy Prime Minister and ex-Minister of Energy Alexander Novak announced that a strategy to reduce GHG emissions will start this year.  

A 2020 mini-government reshuffle and the promotion of Novak to Deputy Prime Minister was seen as a response to "green" challenges that Russia's energy sector will have to face in the international arena vis-a-vis the European Union and the administration of US President Joe Biden. Another veteran reformer, Anatoly Chubais, was entrusted with a role of "Climate Czar" and actually improving the ESG situation at home. 

In a separate move, the Central Bank of Russia (CBR) announced in March that it intends to use ESG scores to calculate bank reserve ratios. A nationwide green certification system is also in the works amongst many other initiatives.  

The government is taking up the baton, but so far the drive to introduce ESG ethics has been led by Russia’s leading corporates after big Scandinavian state-owned pension funds started banning investment into their equity because of poor ESG scores.  

Utilities in the front line

Russia’s utility sector is particularly vulnerable to environmental concerns, and power generation makes up just under half of all Russia’s CO2 emissions. The Klieg lights are increasingly focused on the sector and knocking it into emissions-acceptable shape before all these issues become a real problem.  

So far, the only Russia-based utility that has tackled the problem head on is Enel Russia, which last year sold its coal-fired Reftinskaya, which was responsible for about a third of its electricity output, and has started investing heavily into renewable energy. The bulk of the other utilities have made little progress in cleaning up their act.

And part of the proposals being suggested at the moment would force companies to disclose the share of their revenues that come coal-fired power generation; currently none of the utilities report how much they earn from power generated from burning coal, except Enel, which now reports zero.  

In Scandinavia investors have introduced a 5% threshold for utilities, above which they are not allowed to invest. According to investment bank estimates, few Russian utilities would clear this hurdle and several of the bigger utilities companies, such as OGK2, RusHydro and Unipor, earn at least a quarter of their revenues from coal-fired power plants. If the 5% threshold were introduced in Russia then these companies would see a lot of investors leave.  

“For Russian utilities, we believe the dangers of carbon-pricing cash outflows are irrelevant at present; however, it might well become a provisional charge that must be reflected under IFRS rules,” VTBC analysts Vladimir Sklyar and Anastasia Tikhonova said in a recent report. “Over the last 12 months, we have witnessed a growing number of calls for climate-related disclosure to become a mandatory part of public companies’ reporting and auditing. The support for such needs comes from the most significant asset managers and key regulators.”

The problem that analysts are trying to work out is what the cost of carbon will be. The most prominent of the proposals currently on the table reflect the possible expenses on carbon purchases, be they at the prevailing CO2 price or those required to reach Paris Agreement targets. And the uncertainty of these prices is large.

“We estimate such costs could eliminate 9-100% of Russian utilities’ EBITDA, leading to a 35% dividend payment reduction, depending on the CO2 price benchmark used,” VTBC says. “Our conclusion is that such external costs must be considered when making investment decisions, given the 30- to 50-year lifespan of capital-intensive projects in the sector. So far, we have seen such care from Enel, recently joined by Unipro, both of which are guided by their international controlling shareholders' green strategies. State-affiliated utilities broadly remain aloof to the risks of climate-related expenses in the future,” Sklyar and Tikhonova said.

Russia and Paris

A recent Bloomberg article claimed that Russia is “getting left behind in the global dash for clean energy”, but the country is not doing that badly in terms of reducing emissions, as bne IntelliNews reported in the feature “The cost of carbon.” Moscow signed off on the Paris accords in 2019 and is well on track to hit its emissions reduction targets.

Admittedly it set itself a low bar as it chose to bring its carbon levels down from its 1990 Soviet-era levels rather than the Paris Accord norm of 2005 levels.

A 30% reduction from the 1990 level would allow Russia to produce 1,678mn tonnes of CO2 per year, which is only slightly less than the 1,765 mtCO2/yr it was producing in 2017. However, if 2005 is set as the benchmark year then Russia would have to reduce its CO2 emissions by a third from their current levels, or by a hefty 550 mtCO2/yr.

Still, it has already made massive reductions, but these have come not from any environmentally friendly policies, but simply because energy and construction companies have been investing in new, more efficient, equipment that reduces emissions as a side product to boosting profits. For example, carbon emissions form the power sector have fallen by 29% between 1970 and 2017, while those from construction are now a whopping 56% lower in the same period. Going forward, the challenge will be bigger, as between 2005 and 2017 the only sector to see emissions fall was the power industry, while all other sectors saw emissions start to rise again by between 3% and 21% as Russia Inc. began to grow strongly in the boom years of the noughties.

Next step up

Russia’s power sector has just come to the end of another investment cycle and as capex needs fall most utilities have built up war chests and are generating lots of free cash. The power sector is well equipped to make some big changes if called on. All the companies are looking for new ways to grow.

“Despite delivering a robust combined 13.3% [free cash] yield, utilcos remain parsimonious dividend payers, and we expect them to have 5.2% combined dividend yield for FY20F,” says VTBC. “Every company is on the hunt for growth, with dividends of secondary concern.”

Part of the problem is settling on a price for carbon. IMF head Kristalina Georgieva has called for a carbon price that would cause companies to meet the Paris Accord targets, which the analysts say translates into a cost of $75 per tonne. The EU has also already laid out climate disclosure guidelines, but they are not yet mandatory. And the proposed carbon prices vary wildly.  

Sweden has the highest rate of $133 per tonne, with Liechtenstein and Switzerland also over $100. Finland and Norway also have high prices of $72 and $57 respectively, but almost everyone else in the EU has proposed prices of between $30 and $10, and another 23 countries price carbon at under $10, with the majority putting the price at under $5. From New Europe the only countries to propose a price are Slovenia ($20), Latvia ($10), Estonia ($2.3), Kazakhstan ($1.2) and Ukraine ($0.4). The global medium carbon emissions price is $11.1 per tonne.

 

On of the ways to find a workable price for carbon is to allow carbon trading that would let companies smooth out the process of greening their businesses.

“The government envisions a pilot project on CO2 trading to be launched at Sakhalin (Russia's Far East) to reach carbon neutrality for the region by 2025. The project targets CO2 unit trading starting in July 2022, with the duration of the pilot phase until 2025. We are sceptical about seeing any meaningful national carbon price until then,” said Sklyar and Tikhonova.  

Russia and other countries will be forced to put a real price on carbon. Currently just under a quarter (23%) of countries have attached a price to carbon emissions and at some point countries that have failed to do so will be seen as trading at a unfair competitive advantage and will be penalised, forcing them to price their emissions. Emerging markets have been down this road already in the '90s when the US designated countries “non-market economies” as their production took advantage of heavily under-priced, or effectively free, energy thanks to the vestiges of the centrally planned system and hit them with duties to protect its own market.  

“We believe the lack of carbon pricing in the medium term will be considered an unjustified competitive advantage, pushing Russia toward more proactive consideration of launching a Emission Trading System inside the country,” says VTBC.  

Carbon pricing uncertainty makes it very hard to forecast utilities earnings going forward. VTBC calculated the EBITDA for Russia’s major utilities under four pricing scenarios ranging from the IMF’s $75/t to China’s $6.3/t and found that in the worst-case scenario the carbon costs would eat up all of Russian utilities EBITDA, except for the hydropower company RusHydro, which would only see its earnings fall to zero.  

 

Of course, if these costs are applied then the companies would simply pass on them to their customers, but in Eastern Europe where the population are still used to the Soviet tradition of the state providing power and heat for free, dramatically hiking utilities prices is politically a very sensitive topic, as recent experience in Ukraine has shown where the government recently dropped domestic utility tariffs “temporarily”, much to the chagrin of the IMF. Again, the spread of the possible price increases based on the cost of carbon are very big.  

“Our calculations show that CO2 pricing in Russia might drive the end-user electricity price 6-70% upwards, depending on the pricing level chosen,” Sklyar and Tikhonova said.

 

Premium pricing for green energy

The flip side of utilities having to pay a tax for emitting GHGs is that utilities can charge a premium for producing green energy. Currently unlike Ukraine, which has seen a tsunami of green power investments thanks to an extremely generous green power tariff policy, only Enel Russia has made a serious attempt to invest into renewable energy.  

However, that is also beginning to change and it is also being driven by the growing corporate interest in ESG scores: since the start of 2021 half a dozen blue chip companies, which are also large consumers of power, have been actively seeking out and switching to green sources of energy. The list includes fertiliser makers Shekinoazot and PhosAgro, petrochemical company Sibur, gold miner Polyus, Russia’s biggest bank Sberbank, multinational consumer goods company Procter & Gamble and aluminium producer Rusal.

“Though the exact terms of these contracts are not disclosed, we estimate that they are undertaken with capacity prices at par with the market average and electricity day-ahead prices plus a 2-5% premium to the market, depending on the scale, duration and the complexity of the contract,” says VTBC.  

But it is early days. These big consumers of power that have elected to use green power sources still only consume an estimated 87mn MWh, or about 8.3% of Russia’s total power generation, but this share is expected to grow rapidly in the coming years.