Mismanagement and Corruption in Armenia’s Electricity Sector

Executive Summary: Armenia has one of the highest shares of inexpensive hydroelectricity generation; the lowest shares of expensive natural gas generation; and a high share of inexpensive nuclear power generation. Yet it has the highest electricity tariff among the comparator countries reported here. The study conjectures that: (i) forced transfers of funds by energy companies to state-owned chemical plants and foundations controlled by government officials; (ii) non-payment of electricity bill by privileged customers; and (iii) irresponsible pricing policy to be behind Armenia’s high electricity tariff. At current rates, it estimates that the lower bound of losses for population from these corrupt practices are at least $250 million per year (or roughly 2.5 percent of Armenia’s Gross Domestic Product), much of which will likely accrue to the bank accounts of corrupt government officials engaged in regulating and managing the electricity sector.

A. Background

Despite an unsuccessful start, the privatization of Armenia’s Distribution Network in early-2000’s and the subsequent story were lauded as a major success.[1] However, things have changed dramatically after about a decade, with events culminating in a series of protests coined “Electric Yerevan” in June 2015. This article tells a story of mismanagement—policy failures and corruption—that brought Armenia’s electricity network to its knees. We begin by providing a brief overview of the electricity sector and its problems.

Electricity generation

Table 1 shows the structure of the electricity generation in Armenia and individual unit costs. Roughly a quarter of Armenia’s electricity is produced by large hydroelectric plants (Sevan-Hrazdan HPP and Vorotan Cascade) at a fraction of the cost of much more expensive gas-fired facilities (Hrazdan TPP, Hrazdan-5, and Yerevan CCGT).

Recently, the Vorotan Cascade—a profitable state-owned hydroelectric plant—was sold to a little known US company, Contour Global, for $180 million. While few details of the deal, including how the deal itself came to be, were shared with the public, it is known that Contour Global runs two hydropower plants in Brazil with the size of one-tenth of that of the Vorotan Cascade, leaving doubts about the suitability of this operator and the underlying rationale behind the deal. Prior to privatization, the Government received a €50 million loan from German KfW fund to rehabilitate Vorotan.

Table 1. Electricity Generation Cost and Output, 2014

Table 1Source: WB (2014); and PFA estimates.

The Armenian Nuclear Power Plan (ANPP) is the crown jewel of the system, currently under Russian management. It generated nearly 30 percent of Armenia’s electricity in 2014 and is considered the backbone of the system. The World Bank (2014) estimated that if ANPP is closed for maintenance there will be peak hour shortages of electricity supply in Armenia.[2] According to the World Nuclear Association, “an application for life extension will be made (by the Armenian NPP) in September 2016, and the $300 million upgrade of the plant is to commence in 2017 in order to extend its operation to 2026.” It is not clear where the funding for this will be coming from given Armenia’s disastrous budget situation and ongoing economic crisis.

Armenia trades electricity for Iranian gas: 1 m3 of gas is traded with 3 kWh electricity on average during the day. What had initially started as an electricity-to-electricity swap during peak/off-peak hours, has turned into an electricity-to-gas swap the details of which are nearly impossible to understand given the lack of public information.

Electricity distribution

The Russian owned and operated Electricity Networks of Armenia (ENA) is the link between electricity producers and consumers in Armenia and was caught up in a controversy that erupted in June 2015. Starting off as a profitable company under the management of Midland Resources Holding (prior to the takeover by Russian energy giant Inter RAO UES in 2005), it became loss making in 2012: its net profit margin declined from 3.2 percent in 2010 to negative 9.2 percent in 2012. The 2013 audit of the ENA showed significant losses and debt accumulation.

While technical losses declined somewhat over the years (see ENA presentation), the reliability of service remained low. In 2012, outages per transmission line and outage duration were 2.5 and 4 times higher than the average for well-performing utilities (in the US and Europe), respectively. The company’s capital investment had a lot to do with it: it declined from AMD28 billion in 2009 to AMD8 billion in 2012.

In the most recent and controversial development, the ENA proposed an increase in tariff by AMD17 (or 40 percent). During its June 17, 2015 session, the Public Services Regulatory Commission (PSRC) countered this and proposed an increase of nearly AMD7, bringing the daytime tariff to AMD48.8/kWh and the nighttime tariff to 38.8 AMD/kWh. This has marked the beginning of the “Electric Yerevan” movement.

The ENA does not have the resources to adequately maintain facilities (and electricity supply) in the medium term and neither does the government. Some analysis, therefore, wondered if the protests in June 2015 were “encouraged” by the government to bring attention to the upcoming danger and put the blame for the company’s sorry state of affairs on its Russian management. Section C below provides some rationale behind this claim.

B. Cross-country comparison of electricity tariffs

To better understand issues/problems surrounding Armenia’s electricity distribution sector and its cost structure, it is important to compare Armenia with relevant comparators in the Commonwealth of Independent States (CIS). Table 2 presents data on electricity generation, efficiency indicators, and electricity tariffs for residential use across some countries.

The following observations are noteworthy:

  • Armenia has a high share of (relatively inexpensive) hydro generation, third after Georgia and the Kyrgyz Republic.
  • Armenia has one of the lowest shares of (relatively expensive) natural gas generation.
  • Armenia’s share of (relatively inexpensive) nuclear power generation is greater than that in Russia; no other comparator country has nuclear generation capacity.[3]
  • Like Belarus, Georgia, the Kyrgyz Republic, and Moldova, Armenia too imports a significant share of its energy generation inputs (almost 73 percent). In case of Armenia these are gas and nuclear fuel.
  • In 2012, Armenia was in the middle in terms of power transmission and distribution losses (at 12.4 percent) and at par with the average for the developing countries of Europe and Central Asia, at 12.2 percent (not shown in the table).

Despite all of these rather favorable factors, Armenia’s electricity tariff is the largest among the comparator countries.

Table 2. Electricity Generation and Use in Select CIS Countries

(Data as of 2012; unless otherwise noted)
Table 2

Source: World Bank’s World Development Indicators (WDI) Database.

C. Main Factors Behind Electricity Sector Troubles

The following is a list of factors that have contributed to the formation of the high tariff and the deterioration of the sector’s financial conditions in recent years:

  1. Transfers of funds to, and non-payments by, Nairit and Vanadzor chemical plants. State-owned power generating companies (i.e., ANPP, Yerevan TPP, Vorotan, and High Voltage Electricity Network) were used as “cash cows” for quasi-fiscal transfers to those chemical plans.[4] The total debt of those two plants to the power sector was estimated at AMD22 billion (see WB (2014), p. 43). It is noteworthy that Nairit’s debt to the power sector came with government guarantees, which were never called. This situation created significant holes in the financial position of the electricity generating companies, forcing them to take lots of expensive short-term debt, and resulted in subsequent increases in the cost of electricity generation.The following is a list of factors that have contributed to the formation of the high tariff and the deterioration of the sector’s financial conditions in recent years:
  2. Transfers to foundations controlled by government officials. The electricity companies and ENA were forced to transfer massive sums of money to government-connected foundations and entities. A Eurasianet report confirms that ENA made millions of dollars in transfers to a charitable organization chaired by Serge Sargsyan, among others. To this day, the power sector pays for operation and capital renovation of a large center used for official government receptions (see WB (2014), presentation; p. 43).
  3. Non-payment of electricity bill. Certain categories of clients largely connected to the political elite have over the years not paid for their electricity bill. Estimates of this are difficult to come by from public sources, but the problem is believed to be serious among experts that the authors of this note interviewed.
  4. Irresponsible pricing policy. ENA’s financial position has been undermined on a regular basis by the PSRC using the following scheme: in calculating the end-user tariff, the PSRC (intentionally) overstated the amount of electricity generated by (inexpensive) hydro and nuclear generators to keep the tariff artificially low. The actual outcome had much more gas-generated electricity resulting in higher costs for ENA while it was stuck with (artificially) low tariff. In addition, in the past couple of years, in order to keep the tariff under control, the PSRC refused to approve ENA’s much needed investment plans.

A corollary to this is ENA’s regulator-imposed cost structure. ENA pays to the generating companies a fixed cost and a variable cost. Instead, it can only charge a variable cost to its customers. This creates a situation that when the demand for electricity drops to a certain level, revenues are not enough to cover the costs, resulting in loss for ENA. This has had negative financial implications for ENA and may jeopardize reliability of electricity supply in the future due to lack of resource to undertake adequate maintenance.

A critical factor often overlooked while discussing the electricity issue is that of the population dynamics. Since the average/marginal cost of electricity generation are declining as a function of output/demand, if the demand continues to fall, it will push the average/marginal cost of electricity up. This will subsequently push the tariff higher, which will reduce the demand and increase the cost even further in a spiral. Implications of this for the financial viability of the system can be devastating.

Finally, it should be noted that exchange rate depreciation could not have had a significant impact on electricity cost in Armenia. The reason is that only a small portion of total cost originates from abroad (and is therefore subject to exchange rate fluctuations). Box 1 below explains why the price for nuclear electricity—a seemingly import-intensive type of energy—is not very elastic to changes in exchange rates.

Box 1. Economics of Nuclear Electricity

Much of the costs of electricity generated by nuclear plans are due to the cost of capital, since they are very capital intensive. In the case of the Armenian Nuclear Power Plant (ANPP), its investment had largely been depreciated years ago, making the electricity produced there relatively inexpensive. The cost of fuel for operating nuclear plants is 30-40 percent of total cost (because the share of capital cost is very low). 1/

The World Nuclear Association (2015) notes that price for nuclear energy is not very elastic to changes in the cost of fuel. 2/ Based on a study conducted in Finland, a doubling of fuel prices would result in the electricity cost for nuclear rising by just about 9 percent. For the US, the same source states that doubling the uranium price (say from $25 to $50 per lb U3O8) takes the expected cost of generation from 1.3 US cents per kWh to 1.42 cents per kWh (an increase of less than 10 percent).

_________________________

1/ Details for ANPP can be obtained here. 2/ “The Economics of Nuclear Power”, available here.

D. Calculating Corruption Mark-up: A Cross-Country Analysis

As noted above, the electricity tariff in Armenia is higher among the comparator CIS countries. The following Figures show by how much Armenia’s tariff differs from that of comparator countries, if we take into account the supply factors (e.g., generation structure: hydro, nuclear, and gas) and demand factors (e.g., purchasing power of population).[5]

Figure 1: Hydroelectricity and Electricity Tariff

Figure 1                   Source: Table 2 above.

 Figure 2: Gas–generated Electricity and Electricity Tariff

Figure 2                   Source: Table 2 above.

Figure 3: PPP-adjusted per Capita Income and Electricity Tariff

Figure 3                   Source: Table 2 above.

All three Figures show that Armenia’s tariff is significantly higher than what it should have been—it is located significantly above the fitted lines representing the relations between the tariff and its determinants. The predicted value of the residential tariff using Figures 1-3 is between AMD34/kWh and AMD35/kWh, instead of the current AMD48.8/kWh. The estimated tariff will be even smaller once (relatively inexpensive) nuclear power generation and (low) generation/distribution losses for Armenia are incorporated into the analysis.

A tariff at AMD35/kWh appears reasonable also because the system actually worked under this kind of tariff for years ago (once inflation is adjusted for). However, whether this tariff will cover the system’s sizable investment needs going forward will largely depend on its ability to reform and use its resources productively.

The difference between AMD48.8/kWh and AMD34-35/kWh (i.e., AMD14-15, or approximately 40 percent markup over the expected tariff using cross country comparisons) is the corruption markup effectively charged by Armenia’s regime to its population. In a typical year (with production at average 7.8 billion kWh per year), this will generate nearly $250 million (or approximately 2.5 percent of Armenia’s Gross Domestic Product) of excess revenue/surplus per year. How this surplus will be distributed between government officials, ENA, and generating companies depends largely on the complex relations and the bargaining power between those entities.

E. Implications of Excessive Electricity Tariffs

This markup has important economic and social implications. High electricity tariffs have negative impact on economic activity across a broad range of sectors since they increase the cost of manufacturing and services for all companies/producers.

In addition, high electricity tariffs reduce the household income available for spending on food and other necessities and contribute to increase in poverty. [6] Using Armenian household expenditure data, World Bank (2014) found that: (i) energy spending is already estimated at 10 percent of total household expenditures, which is considered the energy poverty level internationally;[7] (ii) as a result of 2013 gas and electricity price hikes, energy expense share increase was highest for the poor (by 13.6 percent); (iii) the tariff hikes are estimated to have increased poverty by 3 percent.

Apparently, Armenian households are among the most vulnerable ones to an energy price shock among a wide-cross section of CIS countries according to another recent World Bank study. Ruggeri, Olivier, and Trimble (2013) find that the poverty rate in Armenia will increase by 6 percent as a result an energy tariff increase (standard for the group of countries used in the study), one of the highest increases in the group.

Figure 4. Poverty Incidence and Estimated Increase Due to Tariff Hike

Figure 4                    Source: Ruggeri, Olivier, and Trimble (2013), p. 89.

Finally, increase in electricity (and gas) tariff will also push the low-income households (unable to afford gas- or electricity-power heat) to use wood for heating, which will have negative consequences for public health and Armenia’s already very low forest cover. Poor households reported cutting down on expenses for healthcare and children’s education to cope with energy price increases.

The leaders of the “Electric Yerevan” movement against the proposed increase in electricity tariff must have had these concerns in mind, at least implicitly. However, not only they did not succeed in their demands, but the resulting outcome was economically and socially inferior. Instead of reducing corruption and inefficiencies in electricity regulation, generation, and distribution, the events in June 2015 led to a government subsidy to the sector (to cover losses partially generated by privately-owned companies) using budget resources. In a classic example of “privatizing the gains and socializing the losses”, Armenia’s taxpayers were forced to pay for the bad deeds of the past, without achieving any meaningful change in the way the electricity sector operates.

 

References

Sargsyan, Gevorg, Ani Balabanyan, and Denzel Hankinson, 2006. “From Crisis to Stability in the Armenian Power Sector.” World Bank Working Papers 74.

World Bank, 2014. “Armenia Power Sector Policy Note,” December; Washington, DC.

Ruggeri Laderchi, Caterina, Anne Olivier, and Chris Trimble, 2013. “Balancing Act: Cutting Energy Subsidies While Protecting Affordability,” The World Bank, Europe and Central Asia Reports, Washington, DC.  Available via: https://openknowledge.worldbank.org/bitstream/handle/10986/12296/9780821397893.pdf?sequence=7

 

[1] The 1997 Law on Privatization provided the legal foundation for the privatization of the power sector in Armenia. Gradually, between 1997 and 2002, privatization of 25 small hydropower plants took place. However, privatization of the distribution network took more time. The first attempt to privatize the network in 1999-2000 failed, allegedly due to flaws in the tender documents and legal framework. Five major international energy companies had expressed interest with four having prequalified, but none submitted bids. The government revised the tender documents and appointed new transaction and legal advisers. It also revised the Energy Law to reduce potential government interference in sector operations. A second tender was held in 2001, but failed. In 2002, a rather inexperienced (financial) company, UK-based Midland Resources Holding, presented an offer and eventually assumed ownership of the distribution in the fall of 2002 (Sargsyan, Balabanyan, and Hankinson, 2006).

[2] To avoid these in 2016 (due to a planned maintenance-related shut-off of the ANPP), the government was planning on turn on some old gas-fired facilities, which as noted above are very expensive.

[3] Ukraine, the only other CIS country that generates nuclear electricity (not shown in Table 2) has a share of 49.4 of its electricity produced by using nuclear generation in 2014.

[4] For example, Vorotan Cascade financed AMD400 million worth of payroll of Nairit (WB, 2014).

[5] While a multi-variate regression analysis would have been a more precise analytical tool to use (that would have allowed for controlling of all factors simultaneously), the results will be almost identical given that all three bi-variate factor analyses (which would have been combined in the multi-variate analysis) individually point to the same range for the estimated tariff (34-35 dram/kWh). The benefit of using bi-variate analysis (such as figures/charts) is that it provides for a better visual understanding of the factors involved and their values.

[6] It should be noted that the household welfare will also decline as a result of reduced consumption of electricity (due to higher tariff).

[7] The term energy/electricity poverty refers to households spending more than 10 percent of their budgets on energy/electricity.

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One Response to Mismanagement and Corruption in Armenia’s Electricity Sector

  1. Pingback: Is Armenia Becoming a Failed State? | PFA Blog

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