Russian shipping and shipbuilding: The league of national champions

Graham Stack, for Radio Free Europe / Radio Liberty

In the 1990s, as the Soviet economy collapsed, the shipping sector was one of the few to bob to the surface, buoyed by international demand for its tonnage. It migrated to offshore tax havens and operated under flags of convenience.

As a consequence, less than 10% of Russian fleets’ business was done in Russia, and a decade of surviving in international waters forced Russian shipping companies to become lean and mean.

Now the ‘Kremlin-garchs’ want to change things: they want Russian shipping home again – to increase added value in the energy sector by serving national oil and gas giants. And with the prospect of demand for ships mushrooming due to giant offshore energy projects and Arctic shipping lanes opening, they also want Russian shipping companies to buy Russian-built ships.

Actors in the Sovcomflot-Novoship merger

The vehicle for state policy in maritime shipping a new ‘national champion’, created by merging the state’s 50.3% share in Novorossisk-based Novoship, the world’s twentieth largest carrier, into 100% state-owned Sovcomflot, the world’s sixteenth largest. The result is the world’s fifth largest shipping company.

The driving force behind this policy, of which implementation started in 2007, is the former Minister of Transport Sergei Frank, himself originally from the shipping industry in Vladivistok, moving to the Ministry of Transport in 1995, and becoming minister in 2000. Frank had advocated such a merger while in office. In 2004 he left the ministry to become CEO of Sovcomflot, evidently tasked with implementing the merger and effectively renationalizing Novoship.

2004 can be considered the birthyear of the new era of industrial restructuring of state-owned assets and related private assets in Russia, including renationalisation of the latter through ‘market methods’ – a term that however in Russia traditionally has a very broad meaning, including use of legal and extralegal coercion. In the first Putin term, further privatization of state assets was formally on the agenda, but a lack of political will meant that state-owned assets remained in limbo.

In 2004, as a result of Putin’s administrative reshaping of government, a powerful Federal Agency for Industry under Boris Aleshin, an industrialist, emerged with a remit to restructure state assets to create large merged companies or sectoral holdings that could compete internationally. Instead of being privatized, these were to remain under state control, but take on (foreign) strategic investors or conduct IPOs and enter international alliances to attract funds and technology.

Moreover, the Yukos case and the post-Beslan transition to appointed governors in 2004-5 strengthened the Kremlin against big business and regional lobbies.

Alongside the appointment of Aleshin and Frank, 2004 also saw Sergei Chemezov, often regarded as the mastermind behind this plan, and an old friend of Vladimir Putin, take over as head of state arms intermediary Rosoboronexport, and launch a programme of restructuring the defence sector through renationalizing privatised companies. The reshaping of government 2004 also led to the corporatisation and connected restructuring of industrial giants Ministry of Railways and Ministry of Atomic Power, pushing industrial policy firmly to the fore, for the first time since the collapse of the Soviet Union.

Despite this ‘sea change’ in 2004, the Sovcomflot-Novoship merger has been a work of compromise, in particular regarding the regional component: Sovcomflot is registered in St. Petersburg, of which the governor Valentina Matvienko has influence in the Kremlin. Novoship, in its turn, is the largest tax payer in the southern region of Krasnodar territory, the governor of which, Alexander Tkachev, is an influential pro-Putin nationalist whom pundits occasionally tipped as a Putin successor. In addition, Sochi, successful Winter Olympic candidate, is located in Krasnodar. Tkachev was particularly active in lobbying against any reregistration of Novoship away from Krasnodar as a result of a merger, and partly as a result, Novoship will remain an independent affiliate of Sovcomflot registered in Novorossisk.

Frank himself is not overtly aligned with any Kremlin groups. As CEO of Sovcomflot he replaced Dmitry Scarga, appointed to Sovcomflot in 2000 at the age of 30. Scarga was linked to the Petersburg group around the Baltic Pipeline System that includes Alexei Miller, who in the same year became head of Gazprom. In 2005, Sovcomflot filed a lawsuit in Britain against Scarga, by then a ‘senator’in the Federation Council, due to financial manipulations uncovered at Sovcomflot’s British subsidiary causing damages of $200m. Scarga moved to London ostensibly to defend himself. Criminal charges in Russia were subsequently opened against him, and an extradition request filed in early 2008. Scarga is now claiming political asylum in Britain – alongside former Novoship CEO Tagir Izmailov (see below). Both these cases indicate at the very least that Frank can count on support from law enforcement and justice organs.

During Putin’s first term, the supervisory board of Sovcomflot was chaired by Dmitry Kozak, a close Putin aide and reformist liberal with a law background. After the Beslan hostage-taking, Kozak moved to become presidential representative to the Southern Federal District, and was replaced by Igor Shuvalov, also a Putin aide on economic matters and a liberal. Neither of them, nor Frank, are closely associated with the silovik faction of former and current KGB / FSB members – showing that the ‘national champion’ industrial policy launched 2004 currently enjoys consensus support among government groups, and can rely on the backing of law-enforcement agencies irrespective of whether siloviki are directly involved in running the business or not.

Implementing the merger

Such backing from law enforcement and legal organs soon proved necessary, since Novoship management resisted the merger from the start. Despite the state’s 50.3% stake retained, Novoship management exercised de facto control over the company through cross-ownership with subsidiaries and influence over financial flows. The company was growing strongly and expanding its fleet rapidly. But state officials and Sergei Frank argued it was doing nothing to reduce exposure to the volatile spot market, and was suspected of shifting assets offshore.

As in many other cases, the complex financial structures set up by insider management in order to control their companies ultimately proved to be their Achilles’ heel: When company president Tagir Izmailov openly expressed opposition to the proposed merger in 2005, he found himself charged with abuse of position and money laundering, and fled to London. In December 2006, ex-chairman of subsidiary Novoship-Invest, holder of 6.5% of Novoship, shot himself after being summoned for questioning. Days before the merger was finalised, management tried to offload a 14.41% stake held by Novoship’s Liberian-registered subsidiary to Gazprombank – to retain some independence from the new bosses – but Moscow blocked this at the last minute.

Kremlin mistrust of management or ‘insider’ ownership for important companies – such as titanium producer Avisma, car giant Avtovaz, plane manufacturer Irkut or Novoship – appears to be one of the driving forces behind current restructuring. Kremlin officials suspect management ownership – often through cross-ownership of companies by their subsidiaries – of restricting companies’ growth prospects, because insider owners risk losing control of the company, and thus their position, if they take on badly-needed strategic investors. The state then proves its point about vulnerability by coercing management into selling up.

Nevertheless, for all the charges brought against former Novoship management, analysts regarded Novoship as – at least formally – more transparent than Sovcomflot. Novoship disclosed its results on a quarterly basis. Sovcomflot disclosed very little and there is an ongoing criminal case against former manager Dmitry Scarga and other management members, who are accused of defrauding the company.

The league of national champions

What does the Kremlin want of its new national champion? Now that state companies Gazprom and Rosneft have secured control of development of offshore gas and oil reserves (specifically the massive Shtokman and Sakhalin projects), the idea is to create linkage to other domestic sectors to increase added value generated in Russia. Shipping services are the obvious next step. Next in line are the shipyards. Ideally tripartite alliances of Russian oil and gas giants, Russian shipping companies, and Russian shipyards should emerge. Sovcomflot management talk of the merged company acting as a catalyst for the development of maritime clusters similar to the role played by Maersk in Denmark, NYK in Japan, Stena Bulk in Sweden or COSCO in China.

Sovcomflot is moving rapidly in this direction, specializing in energy and ice-class shipping, placing orders home and abroad, and rapidly expanding its fleet of LNG carriers, with large orders placed at Korean and Japanese yards – no Russian shipyard currently produces LNG ships, although Baltic shipyards plans to start in 2011.

Supporting offshore projects is however seen to be only the first step. With the Arctic ice melting due to climate change, the Arctic is opening up both for more energy exploration – the US Geological Survey estimates that 25% of the world’s undiscovered oil and gas reserves are located in the Arctic – and also for shipping route: the North-East passage, if sailed from Hamburg to Yokohoma – is almost 40% shorter than passing through the Suez canal.

The offshore developments are expected to put in place a lot of the shipping infrastructure needed for the Arctic to become a main shipping lane, if present climate change trends continue. Sovcomflot estimates that over the next ten years, Arctic shipping will quadruple in connection with Shtokman alone. Currently there is almost no shipping in this area at the moment, and so there is little current competition.

Sovcomflot is not the only Russian shipping company to be thinking along these lines. The smaller, private Vladivostok-based Primor’e Shipping Company (PRISCO) is also an oil carrier currently increasing deadweight at 18% pa and looking to expand into the LNG market. Prisco is well placed for Sakhalin oil shipping and the company has won contracts to ship oil even against bigger players such as Sovcomflot, with a $150mn contract to ship oil for Exxon in Sakhalin. As the relationship with Sakhalin develops, Prisco expects half of its business to be domestic.

The question for PRISCO is whether Sovcomflot’s status as national champion will not jeapardise its ability to win contracts for Sakhalin, after national champions Gazprom and Rosneft having taken leading roles in these projects. Furthermore, if shipping sector consolidation were to continue, PRISCO, or other private shipping companies, might find itself under pressure to sell out to the state-owned shipping giant.

Meanwhile, having merged into a national champion, rich pickings also loom for Novoship in connection with the planned Burgas-Alexandropolis oil pipeline, in which the Kremlin is involved. According to Renaissance Capital, the company is set to become a preferred partner for shipping Russian oil to Burgas.

In early 2008, the advantages of the merger for Novoship became more evident.
Sovcomflot management outlined significant synergies in both revenue generation and on the cost side, including attracting new clients with, for instance, right of first refusal contracts, and savings potential through joint purchasing, cheaper debt financing and the reduction of administrative expenses.
Despite the fierce resistance from Novoship management, minorities and investment banks were mildly positive about the merger – pointing to the chances to increase liquidity and create economies of scale. The merger should produce both synergies and diversification: Novoship is a classic tank oil carrier working the Black Sea routes, while Sovcomflot concentrates on the ice-bound Arctic and hi-tech transport of liquid natural gas.

Analysts argue that size does matter when it comes to international competitiveness, and that the new company will enjoy considerably more pricing power. One of the tenets of the state shipping doctrine has been to move away from the spot market and time charters – where everything is short term and subject to oil price fluctuations – towards establishing long term contracts with direct customers.

Most importantly, in January 2008, Sovcomflot signed a cooperation agreement with state-owned oil pipeline monopolist Transneft for oil shipping to the Burgas-Alexandrupolis pipeline. The January 2008 agreement envisages Novoship becoming the seaborne carrier linking the Transneft pipeline ending in Novorossiysk with the new Burgas-Alexandrupolis pipeline in Bulgaria and Greece that bypasses the Turkey-controlled Bosphorus.

The agreement is very positive for Novoship, since it will support the targeted shift from the volatile spot market towards more sustainable pipeline-like utilisation. However, this deal also showed that the Sovcomflot merger was by no means purely a case of industrial restructuring. It was also a key component in the Kremlin’s pipeline policy looking to expand and diversify its oil and gas pipelines to Europe, while crowding out other competitor pipelines bypassing Russia. This means that the company is of strategic interest to the Kremlin, which could in the future run counter to commercial considerations.

The merged company is correspondingly emitting contradictory signals in terms of its interest in boosting shareholder value and internationalisation.

The new Novoship board appointed in January 2008 is positive sign in this regard, including three independent directors, a rarity in Russia, with two of them non-Russian: Marlen Manasov, managing director of UBS Securities and Robert Sasson, an investment banker, former Head of EBRD Mission in St. Petersburg. Analysts agreed this indicated Sovcomflot was intent on boosting Novoship capitalisation in preparation for an IPO of the entire group.

However, in February 2008, this policy experienced a significant set back, as state interests prevailed over commercial. Inside sources reported that Sergei Frank had been lobbying for independent directors to join the Sovcomflotboard, specifically Morgan Stanley’s Elena Titova and Deutsche Bank’s Charles Ryan. But instead, state officials supported Andrei Kostin, CEO of state bank VTB – and most significantly the new CEO of Transneft, Nikolai Tokarev, a probable former KGB man. Tokarev’s inclusion instead of an independent director indicated that strategic state interests would prevail over commercial considerations in running the company as a member of the league of ‘national champions’.

Uniting Russia’s struggling shipbuilders

The Novoship merger was the prelude to a sweeping overhaul of the shipbuilding sector, the cornerstone of which was the presidential decree of March 9th, 2007, “On the Establishment of the United Shipbuilding Corporation” (USC). This decree provided for consolidating all state-owned assets in the shipbuilding branch, totalling around 40 companies, into a holding with 100% state ownership.

The Sovcomflot-Novoship merger was child’s play in comparison to setting up the USC. The template for the USC was the United Aircraft-builders Corporation (UAC) established in 2006. However, here there are also substantial differences: the aircraft industry consolidation came initially ‘from below’, with considerable consolidation between Irkut, Sukhoi and MiG already underway. Moreover, the Russian aerospace industry includes some very internationally competitive production, such as the MiG and Sukhoi fighter jets, around which a successful company might be built.

Government officials seem, in contrast, to have made decisions about the USC at speed and without consultations. The USC bundles all existing state shareholdings in maritime shipbuilders. There was a strong political flavour to its launch, with much telegenic championing of ‘national shipbuilding’ by at that time potential presidential sucessor Sergei Ivanov. At the same time, relatively efficient fully privatised outfits, such as Petersburg’s Baltiskie Zavody and Northern shipyards, both owned by oligarch Sergei Pugachev’s United Industrial Corporation group, were not invited to join.

The formation of the new holding is not to be completed until 2009, and is already well behind schedule. In its final form, the USC will unite 40 odd companies from Kaliningrad to Konsomolsk-on-Amur, ranging from federal state unitary enterprises (FGUPs) to joint stock companies where the state is only a minority shareholder. Alone the process of inventorying FGUP’s assets and converting them into joint stock companies is, Sergei Ivanov has himself admitted, extraordinarily laborious. The need to facilitate integration influenced the decision to structure the company along regional lines, instead of functional roles; there are to be regional centres in Petersburg, Severodinsk and Vladivostock.

In fact the operation has already run into considerable difficulties, reflected in personnel turnover in top positions. There was initial confusion over who would head the supervisory board. Originally it was expected that Sergei Ivanov would do so, then defence minister Valery Serdyukov was tipped, and finally deputy prime minister Sergei Naryshkin got the job in July 2007.

The difficulties in putting together the corporation were even more apparent regarding the crucial position of CEO. Alexander Burutin, first head of the USC and charged with swift implementation of the presidential decree, resigned in September 2007 after three months of fruitless negotiations with shipyard managements about the terms of their integration. It took over a month to find a replacement for Burutin, with the first choice candidate for the job, Andrei Dutov moving instead to head the State Industry Agency. The next best candidate, retirement age Yury Yarov, a former cabinet minister, in the 1980s boss of current prime minister Viktor Zubkov, was finally appointed October 23, with six months having lapsed since the presidential decree.

What does the Kremlin expect from USC?

The declared goal of the USC is to strengthen commercial, not military, shipbuilding in Russia. To cite Vladimir Putin’s annual address to parliament 2007, the modest goal of USC is ‘for Russian shipbuilding to occupy a decent niche on the world market’.

Currently, Russia basically has zero market share in the global commercial shipbuilding industry. Whereas Japan and South Korea each produce 70m tonnes deadweight per year, Russia turns out only 1m, lagging behind Vietnam, Iran and Turkey. But Russian companies place orders worth $1bn for ships each year, 80% of which go abroad. In fact, 80% of Russian ship-building output is for naval procurement. The imbalance is a legacy of the Soviet era, where naval shipyards were concentrated on Russian territory, with merchant fleet ships being built in Poland, Finland and East Germany, and Ukraine.

As a result, even now that state defence procurement is soaring, Russian yards are on average only working to one third of their capacity. This makes the idea of Russian commercial shipping companies placing a higher proportion of orders with Russian shipyards so alluring.

However, Russian shipyards largely fail to compete even on the domestic market. They suffer from productivity levels far lower than South-east Asian countries. They are also unable to achieve turnaround times anything like the Asian countries, on average half as fast, which is critical, or reliable. Furthermore, Russian shipyards lack the capacity to build the ships with over 80,000 tonnes deadweight that enjoy wide global demand. One major problem here is the location of major shipyards, such as the Admiralty and Baltic shipyards in the historical heart of Petersburg, where there is simply no room to expand

The call of the Arctic

Despite this seemingly hopeless position, Russian planners have identified a market niche they believe Russian shipyards could fill. The grand plan for the ship-building sector is to build vessels to service the Shtokmann gas field and the Pacific shelf projects, as well as for the Arctic shipping routes expected to increase fourfold over the next 10 years.

Government estimates put the number of platforms needed for offshore oil and gas production by 2030 at 40, the number of 85 specialized ships at 80 with more than 140 support ships needed. Demand is set to boom for atomic icebreakers, hydrographic craft for exploration, ice-class oil tankers and LNG carriers, as well as platforms for oil and gas drilling, and pipeline-laying and transport ships

The policy is realistic in looking for Russian shipping to occupy a specialist niche – ships specially suited for Arctic operations. Thus the USC does have a vision going beyond the next elections: an alluring vision of Russia’s twin evils – dependency on budget money and dependency on the resource sector – cancelling each other out – with military shipbuilding diversifying into commercial, and the economy as a whole beginning to put added-value on its resource base.

However international competition still has a head start in tackling these new challenges. Japanese and Korean yards dominate global production of LNG carriers. Even in ice-class shipping, the pioneering role is held by Norwegian Aker-Kvaerner producing double-acting icebreakers (with a stern that can be deployed as an icebreaking bow). Aker-Kvaerner is already supplying freight ships to Norilsk Nickel for year-round shipping between Dudinka and Murmansk. Russian shipbuilding is going to need the sort of hidden protectionism the national champion policy implies, but the costs will be borne by the projects they supply.

In November 2007, the Ministry of Energy and Industry authored a federal target programme to support this technological transition, called “Development of civil marine technology 2009-2016”, which envisages R140 investment for this time period, of which around R100bn will come from the federal budget. The programme focuses on financing R&D and modernising testing and design bureaus. The funding is also sufficient to purchase foreign licences especially for LNG tankers. However, the programme does not foresee direct budget investment in upgrading the shipyards themselves.
The Kremlin’s grand plan thus hinges on creating a chain of ‘national champions’ to increase added-value generated in Russia from the resource sector, comprising Russian energy giants, Russian shipping giants, and a Russian shipbuilding giant. This chain can be extended into supplier sectors. For instance, ice-class shipping requires high-grade steels, of which steel giant Severstal is planning to increase production, launching an investment programme for this purpose worth R850m through 2009, in time for the start of construction of LNG and modern ice-class tankers in 2011.
What use is USC?

An additional question mark over USC is that market forces were already pushing the most efficient shipyards in this direction. Such shipyards are currently either ignoring the intervention of state officials, or regard them and USC as a threat to their efficiency. The most capable shipyards picked up on the new source of demand long before government officials. In recent years, for example, Admiralty shipyards has built five ice-class tankers for Sovcomflot and five for Lukoil. But it is precisely Admiralty shipyard management that has expressed deep misgiving about the corporation – and having to undergo a complex metamorphosis from unitary enterprise to joint stock company, entailing loss of decision making freedom.

Management is particularly troubled about how much freedom the company would retain to conclude contracts independently. In particular, since the USC is to have a two level structure, with separate shipping centres for the West (St. Petersburg and Kaliningrad), the North (Severodinsk and Murmansk) and the East (Vladivostok), united under the umbrella organisation USC, constituent companies are afraid of excessive bureaucracy and loss of the flexibility that is crucial to making effective business decisions.

Two of the most advanced shipyards in terms of producing for offshore projects are Petersburg’s Baltiiskie Zavody and Northern shipyard, both of which are affiliates of oligarch Sergei Pugachev’s United Industrial Group. There has been no attempt to strong-arm these companies into joining, which is in some ways a positive sign, but also questions the rationale behind the project.

Analysts argue that both these shipyards should comprise the core of any Petersburg-based shipbuilding holding. They have also been trailblazers in terms of restructuring, proving that private capital is more effective than government ministers in turning industry around: Baltiiskie Zavody is embarked on a complete relocation from constricted premises in Petersburg’s historical heart to the expanded facilities at out-of-town Northern Shipyards.

Baltiiskie Zavody is Russia’s main producer of nuclear and diesel powered icebreakers, and The UIG shipyards are active in moving into the Arctic shipping business, including preparation to build LNG tankers that are currently not built in Russia at all. Production is slated to commence in 2011, in time for start of operations at the Shtokman offshore gas field in the Barents Sea. In contrast, the state is dragging its heels on holding tenders for constructing shipyard facilities large enough to build ships over 80,000 tonnes, especially large LNG tankers.

Confirming this trend of efficient companies responding swiftly to energy sector demand, the to date largest shipbuilding contract resulting from the Shtokman field development – for two marine drilling platforms worth $2.5bn – went to the privately-owned Vyborg ship-building yard. Vyborg shipbuilding yard that hopes to secure four further such contracts, will also not be part of USC. Vyborg shipyard was recently acquired by influential Petersburg financial group ‘Bank Rossiya’, reputed, as is also Sergei Pugachyov, to enjoy some access to Vladimir Putin.

Further questions were then asked of the efficiency of state-owned yards when in February 2008 the Norwegian shipping concern Odfjell terminated a $500m contract with the Sevmash shipyard, based in Severodinsk, the Russian producer of nuclear submarines. Sevmash called the contract for twelve 45,000 tonne tankers the ‘deal of the century’ when it was signed in 2004.

Odfjell claims that the first tanker was slated for delivery in September 2007, but will not be ready until May 2009, and that the cost of the order has risen from $500 million to $544 million. Following termination of the contract, Sevmash will also be liable for damage claims.

Sevmash for its part argues that the soaring price of steel is to blame for the rise in costs, but in fact this is not Sevmash’s first failure of this kind. The yard also mismanaged a large Indian order to reequip the Russian aircraft carrier Admiral Gorshkov for sale to India. Originally planned for 2008, the handover has now been postponed to 2011, a delay that cost the previous Sevmash management their jobs.

The Sevmash case points again to weak management as a major problem for many state-owned shipyards, and it is unclear how the USC intends to improve this situation.

Conclusions

- The basic goal of boosting commercial production by former naval shipyards is positive, since, if successful, it will increase international economic integration of the sector and hinder the emergence of any ‘military-industrial complex’ lobbying for arms spending increases. The Arctic shipping / offshore niche has some real potential.

- The increase in state involvement should not be exaggerated. In shipping, there remain three major and expanding private shipping companies. In shipbuilding, the state has not yet tried to persuade or pressure private companies into joining the holding – even major ship-building companies with considerable defence significance such as Baltic and Northern shipyards remain in private hands.

- The selective use of criminal charges apparently to pressure former Novoship management into consenting to the merger is extremely disquietening.

- The new focus propagated for shipping and ship-building on offshore projects and the energy sector will add to Russia’s assertiveness in this area, in terms of ‘resource nationalism’. Multinationals are often regarded as reluctant to contract out to Russian suppliers, and the Kremlin is intent on maximising added value in the energy sector as part of its diversification strategy. Moreover, the increasing, and increasingly politicised, focus on the Arctic waters as being of strategic significance for Russia will lessen readiness to compromise on questions of demarcation of territorial waters.

- The developing system of ‘national champions’ is potentially detrimental to competition and the market mechanism, since it is likely that national champions, such as Gazprom and Rosneft, in the energy sector will prefer other (state-owned) national champions in shipping and ship-building, even where private companies are more competitive. Furthermore, state-owned companies that have proved themselves efficient outside of national corporations, such as Admiralty shipyards, or the Sukhoi holding in aircraft construction, risk being shackled to inefficient loss-making companies.

Green as camouflage for Kremlin’s energy agenda

Graham Stack for business new europe

Far from flooding the carbon trading market with hot air, Russia is posing as an environmental purist and using the green issue to push the Kremlin’s energy agenda.

After vacillating for months, Russia’s decision to sign off on the Kyoto Protocol in January made the international agreement that is supposed to regulate international emissions of gases harmful to the environment a real document.

One of the quirks of the document was the chance it gave Russia to sell lots of “hot air:” because the 5% reduction target for 2008-2012 took 1990 as its baseline, before Russia’s post-Soviet industrial collapse, it handed Russia 300m tonnes of carbon emission indulgences to dispose of. Environmentalists and traders were waiting anxiously to see what Russia intended to do with the Kyoto lottery win. Would Russia swamp the nascent carbon trading market with cheap hot air, allowing European companies to ramp up emissions with impunity and turning Kyoto on its head?

They needn’t have worried – the opposite seems to be true. After years of bureaucratic foot-dragging, Russia’s paper-pushers have finally drawn up the regulatory framework for joint implementation – the system whereby companies from signatory countries can harvest carbon credits for own consumption or for trading by investing in carbon-reduction “joint implementation” projects in other signatory states.

And the big surprise: far from letting the lottery win go to their heads, Russian officials have outed themselves as environmental purists.

Vsevolod Gavrilov, head of the natural resources department in the economy ministry, announced at a press conference on March 13 that his department will process joint implementation projects – of which 60 have already been drawn up by investors – according to a rejection-based approach. “The most correct approach is forbidding everything, but allowing certain things to go forward. The worst approach is to approve everything, but say certain things are forbidden,” Gavrilov said. “We are working according to a principle of rejection – we have no interest in creating the largest carbon emissions market. Our goal is to promote norms of ecological responsibility.”

Many potential foreign investors hoping for a slice of carbon credit action in Russia were dismayed at his words, although Gavrilov’s statement was consistent with earlier assertions in January that, “the key goal is to attain ecological benefits both globally and locally here in Russia,” rather than for Russia to earn big bucks.

Considering that the Russian government originally hemmed and hawed over signing up to Kyoto, leveraging a very strong bargaining position to secure EU consent to its WTO bid, is it really the case that Russian officials are now “greener than green” and intent on implementing the agreement for the sole good of the global environment? Or is Russian bureaucracy simply displaying its usual regulatory zeal? Or is there a more sophisticated Kremlin agenda for joint implementation, as for most everything else these days?

Trailing Ukraine in carbon readiness

The proposed stringency regarding project approval follows a long period of foot-dragging by government over establishing the procedures for joint implementation – meaning that for potential investors, time is running out. “The window of opportunity is closing now that with 2008 the commitment phase of the Kyoto protocol has already started,” says Maria Kovalenko, carbon trading analyst at pointcarbon. “Projects have to be completed before 2012, the emissions reduction target date. Newcomers should consider carefully whether there is sufficient time left.”

“Ukraine established its procedures in 2006, and they already have one project up and running,” she says. Not surprisingly, pointcarbon’s CIS office is located in Kyiv and not Moscow. The Ukraine project, the Podolsky cement factory, consists of a €140m investment to replace wet cement production with dry technology. Ireland-based CRH Finance is providing the investment and will acquire the resulting carbon credits.

Konvalenko explains the Russian time lag with the detailed work that the government has performed in establishing procedures for project approval – a testimony to Gavrilov’s professed purism. The very real complexity of the process is all down to the concept of “additionality:” joint implementation projects have to prove that the emissions reduction would not take place without the incentive of carbon credits, to cut down on freeloaders’ distorting the carbon credit market. Needless to say, the bureaucratic effort in ascertaining this additionality is immense. Joint implementation projects are both subject to approval at the national and UN level to guard against any softening of criteria leading to carbon credit inflation. Thus there is ample justification both for delays in establishing procedures and for future delays in approving projects. “Joint implementation is in itself a very slow process,” says Kovalenko.

In Russia, the situation is made even more complex by the currently distorted incentives set by state-controlled prices for power and gas – controls that are about to be phased out. This means that rising domestic energy prices will anyway force companies to invest in improving energy efficiency, without any need for the additional incentive of selling carbon credits.

So the ministry, argues Astrid Moe of Norway’s Fridtjof Nansen Institute, has a powerful argument for handling joint implementation strictly: to fence off “real” carbon reduction emissions from simple energy efficiency improvement stimulated by price rises. “I believe the Ministry of Economy wants to steer [joint implementation] into projects where new technology is needed and let the bulk of easy reductions be taken care of by price reforms, as well as emissions trading further on.”

This is view is shared by Ingo Ramming, executive director of Carbon Trading and Finance, a joint venture established by Gazprombank and Dresdner Kleinwort. “This is a very important statement,” argues Ramming, referring to Gavrilov, “coming against the background of controversies last year about projects in India and China where the additionality of projects was disputable. It seems the Russian authorities wanted to make quite sure about additionality. I would even say it was an important statement upholding the credibility of joint implementation in Russia.

This seems to back up eco-purist Gavrilov when he says, “unfortunately not all the investors are taking this opportunity the right way, some see it as a way to get a freebie without doing any work. We want to avoid these speculative projects.”

Green as camouflage for energy agenda

However, Gavrilov not only surprised potential investors by the stringency of his department’s approach and his green purism, he also surprised them by naming Russian oil major Surgutneftegaz as a shining example of how to implement carbon emission reductions – by capturing the associated gas for power generation instead of simply flaring it.

This relativises Gavrilov’s ecological credentials: since 2007 it has been established Kremlin policy to clamp down on flaring. President Vladimir Putin even mentioned the issue in his last state of the nation speech in April of 2007. Government ministries have started drawing up regulatory measures to encourage a shift towards utilizing associated gas. The Kremlin’s motivation is for cutting flaring is, however, not ecological, but to maximise Russia’s energy clout. This raises the question of whether the tight bureaucratic supervision, combined with the small remaining window of opportunity for joint implementation projects, is not intended to channel Russia’s carbon credit wealth towards strategic projects backed by the Kremlin.

The case of associated gas is one where Kremlin strategic goals and carbon emission goals coincide. However, a carbon-reducing classic – switching power generation from coal to gas – fundamentally contradicts Gazprom’s ideas about how the Russian power sector should develop, and is thus likely to be a non-starter.

Gazprom is lobbying for exactly the opposite to happen: for an increase in the use of coal in Russia, to free up gas for more profitable exports. A planned rise in gas prices should stimulate this process. Gazprom has also just been given the go ahead to merge its considerable power generation assets with those of the SUEK coalmining concern, paving the way for increased use of coal domestically. According to Moe, this means that joint implementation projects envisaging a coal-to-gas switch for Russia are unlikely to win approval, however impeccable their environmental credentials. Russian regulatory authorities have the power to simply delay project approval until time runs out for implementation. So Gazprom’s preferences are likely to shape policy regarding carbon credits as it does in most other policy spheres as well. And all the more so for that Gazprom is hatching big carbon plans itself.

Phillip Dewhurst, head of PR at Gazprom’s London subsidiary Gazprom Marketing and Trading, a vehicle for global carbon credit trading, calls Russia “the Saudi Arabia of carbon.” Gazprom M&T has already made its debut on the world’s carbon trading market, acquiring carbon credits by investing in a Brazilian bioethanol plant and selling to Japanese company Marubeni. According to Gazprom M&T, however, these deals were just testing the water. Gazprom’s ultimate aim is to set up a scheme systematically bundling carbon credits with its own natural gas sales, marketing the package as “carbon-neutral gas.” In this way, Gazprom can leverage Kyoto to expand market share in Europe, in particular facilitating direct access to industrial customers, one of its long-term strategic goals.

And Gazprom is not going to be short of carbon credits. According to Anna Korppoo also of the Fridtjof Nansen Institute, 52% of proposed joint implementation projects and 60% of proposed emission reductions in Russia involve refurbishing gas pipelines to reduce leakage. This means that Gazprom, monopoly owner of Russia’s gas pipelines, will be the driving force behind joint implementation in Russia. Korppoo notes that gas pipeline projects involve a minimum of foreign actors, some of which are anyway Russian companies registered overseas.

In general, Korppoo notes revealing details about proposed joint implementation projects in Russia compared to Ukraine: an extreme concentration of the Russian projects in few hands, with only 17 foreign actors spread between 38 projects, compared to 15 foreign partners for a total of 15 projects in Ukraine.

These figures also point to joint implementation in Russia being nationalized to further the Kremlin’s strategic goals – with restrictive bureaucratic means being used to channel credits to national champions, while maximizing their value by restricting supply to the market as a whole.

Green fields for biofuel, blue skies for Sukhoi

It’s hardly by chance that the same week Gavrilov outlined government policy on joint implementation, a trio of political heavyweights called on biofuel to become an important new string in Russia’s energy bow. Russia currently has no bioethanol production, but the agriculture ministry estimates there are 20m hectares of idle arable land that could be brought back into use for biofuel production – supported by carbon credits.

No less than Vladimir Putin got the biofuel ball rolling. “Considering that the significance of biological fuel in the global energy sector is steadily growing, special attention will now be paid to countries that have enough arable land to ensure the necessary amounts. Certainly, Russia will occupy a special place among these countries. This is becoming no less important for us than the use of common national resources in the hydrocarbon sector,” Putin said at a meeting with top officials of the State Duma on March 11, according to Interfax.

Duma speaker Boris Gryzlov was even more direct, saying: “we should capture this market, and then we will dictate our terms not only on the sale of gas and oil, but also of biofuel. This is a realistic opportunity for us.”

The day after Putin’s call for action, Prime Minister Viktor Zubkov, attending a timber industry conference, announced a state programme to be launched with the goal of achieving 2m tonnes of biofuel production per year, including construction of some 30 biofuel plants. The timing of his announcement in front of timber industry representatives might indicate future utilization of timber waste for bioethanol production, something done in Soviet times – and also chiming with Kremlin plans to increase added-value in the forestry industry,.

The Kremlin carbon agenda is not limited to energy. At least one of the Kremlin’s pet high-tech projects is also lining up to gain from the carbon credit bonanza: Russia’s flagship civil aviation project, the Sukhoi Superjet, a state of the art medium-range passenger plane yet to go to serial production, boasts significantly lower carbon emission values than its competitors – making it eligible for carbon credits under Kyoto. As Maria Konvalenko of pointcarbon points out, “in Russia a lot of business is very close to politics, and sometimes it is simply the same.”

Putin’s Finest Hour a Distant Memory as Hopes for Democracy are Dimmed in St. Petersburg

Graham Stack for Russia Profile

For someone who loves to display a good memory for facts and figures, Russian President Vladimir Putin suffers from severe amnesia regarding one decisive episode in the history of his country: the putsch attempt of 1991. The residents of St. Petersburg who took part in resisting the putsch remember those days more accurately than Putin.

Putin himself now jogs their memory for all the wrong reasons. For the first time since the Soviet era, there is an almost complete lack of political alternatives to the current administration, and the government does all it can to maintain the status quo by controlling TV and “managing” democracy. Putin’s cricket score popularity ratings and the economy’s snowballing growth also help.

Every revolution has its Thermidor

Alexander Rahr mentions in his Putin biography “The German in the Kremlin” that, on the first day of the putsch, the mayor of St. Petersburg and Putin’s boss Anatoly Sobchak was at Boris Yeltsin’s dacha in Moscow. The KGB had orders to arrest Sobchak immediately upon his return at St. Petersburg’s Pulkovo airport, but “To their great surprise, when they arrived, they found the plane guarded by armed police units. Putin had returned from vacation and learning of Sobchak’s pending arrest, decided to defend him by all means possible, thus openly turning against his former employers.” According to Rahr, Putin arrived at the airport in person, put Sobchak in his car and drove him at breakneck speed into town, where crucial talks were held with the head of the city’s KGB and military. The negotiations resulted in the law-enforcement agencies agreeing not to intervene.

Alexander Sungurov, human rights activist and senior lecturer at the St. Petersburg branch of the Higher School of Economics, was a democratic deputy in the Leningrad Soviet at that time.

“Perhaps the most important thing in St. Petersburg,” he remembered, “was the stance of the head of police, who refused to follow orders from Moscow to disperse demonstrators. In addition, Petersburg was the only city where even the Communist Party showed some opposition to the putsch, demanding that Gorbachev be released and shown on TV so that people could see he was alive.”

Sungurov continued to work as a deputy of the St. Petersburg Legislative Assembly throughout the 1990s. “I remember Putin well, of course. He was a perfectly normal aide to Sobchak. He was someone we often spoke with. He’s basically a conformist, loyal to the team of which he is a member. When he was on Sobchak’s team, he was loyal to Sobchak.”

At present, Sungurov is a member of the Presidential Committee on Human Rights under the chairmanship of Ella Panfilova. “You have to understand that every revolution is followed by a downturn, every revolution has its Thermidor. That’s just a law of physics. The question is just how far it goes. The only real alternative to Putin was General Alexander Lebed, and if he had become president, things would have been a whole lot worse. So Putin taking charge of the country in the authoritarian phase following the revolution is far from the worst thing that could have happened.”

Sungurov is upbeat about the newly-elected president Dmitry Medvedev. “The main thing is to learn from mistakes and to get ready for the next democratic wave, which I believe will be coming very quickly. For the first time in a century, at least since Vladimir Lenin, the new president will be someone whose parents have a higher humanitarian education. Medvedev doesn’t belong to the KGB Corporation.”

“If Putin had stayed president it would have been like in Central Asian republics,” he added. “But he had the courage to say enough’s enough. The fact that he hasn’t completely gone, but is staying as prime minister, is also understandable. Putin himself said that he is staying ‘because I know what my friends the siloviki are planning for the country if I leave completely.’ Putin can control the siloviki and Medvedev can’t.”

“The real revolution in Russia took place when independent deputies were elected in 1990,” Sungurov concluded. “What happened during the putsch in 1991 was the equivalent of the colored revolutions in Ukraine and Georgia. We’ve been through all that already. We’re waiting for the next stage now.”

What I fought for I still have

Lev Apostolov, 34, now a logistics manager in the book trade, was a student in 1991 and one of the youngest to join the official defense of the Leningrad government during the Putsch.

“I went straight to Nevsky Prospekt and joined in a demonstration against the Putsch. The next day I went back and joined the official defenders of city hall. It seems funny now, but it wasn’t funny then. There were six of us in the brigade – my school friend Jan, another student, a butcher, a burglar (by his own admission). There were groups of martial arts enthusiasts and a lot of Afghan veterans.”

“We were assigned to patrol the Bolshaya Morskaya Street and to build a barricade right beside a cinema called Barrikada. So we piled up trash cans,” said Apostolov. “We were given arm bands and told not to jump on tanks if they appeared. That whole night was very tense, full of rumors. In the morning came the announcement that the putsch had failed, and they played Bob Marley on the speakers. I remember that the democrats in city hall behaved with great dignity and calm. Sobchak gave a splendid speech – fascism will not pass things of that sort.”

“Yeltsin was a hero at that time. Without any publicity at all, the democrats could gather thousands and thousands of people. Now look at the Dissenters’ March. They advertise on the radio, on Ekho Moskvy. And still no one goes. Everyone was politicized back then. Perestroika was a great time. Of course, there were huge hopes, many of which were never fulfilled, but I don’t regret anything. What I was defending then was my right to travel, to hear the music I want to, to read the books and watch the films I want to. And these rights I still have.”

With regard to the status quo, Apostolov said, “The biggest problem with Putin is that, if they are tightening the screws now, when there’s no reason to, what on earth are they going to do when the price of oil falls, when the problems start? I can’t understand why they want to turn people into idiots with this farce of an election. I took my bulletin with me from the voting booth.”

Fed up with being afraid

The day after Dmitry Medvedev took 70 percent of the vote despite his candidacy having been announced just two months previously, around 1000 members of St. Petersburg’s liberal opposition forces gathered to hold a Dissenters’ March, showing that not everyone had forgotten what democracy is about. March 3 is also the anniversary date of the overthrow of the Romanov monarchy and the establishment of a parliamentary democracy in 1917. But among those marching, memories of 1991 were more important than those of 1917.

Anatoly Sergeev, 62, who calls himself a “simple worker,” reminisced about how different it was all back then. “I went to St. Isaak’s Square and joined a brigade of official defenders. We had no weapons. We built barricades. In contrast to today, there were no police trying to stop us. At night we then sat on the rooftops by the square drinking tea. There was fear in the air. But in the end nothing happened.”

“It was a great mistake to let the Soviet Union collapse,” Sergeev argued. “They should have kept the Union – there was a majority in favor of it at the referendum. No one had permission to break up the USSR. The individual republics creating their own central banks out of the Soviet state bank drove the last nail into the coffin. I still like Gorbachev, but he should have been tougher. Sobchak was a thief; the only good thing he did was to rename Leningrad Petersburg. And he acted bravely during the Putsch.”

Turning to contemporary politics, Anatoly pulls no punches. “Putin’s just a puppet, other people are pulling the strings. He has done a lot, but not for me. How can you live on a pension? I have a bad heart and need medicine. I had to pay for my daughter to study somehow. And prices keep rising.”

Despite straitened circumstances, Anatoly is proud of having resisted the putsch. “I don’t regret taking part at all. I didn’t even think twice back then. It’s simply that at some stage you get fed up with being afraid. Why don’t they give us proper elections today? I would have voted for Ivanov, the defense minister, if he had stood. He’s a strong figure. Why did they not let him stand? Why did it have to be Medvedev?”

A child of the revolution

Lena, 46, a school librarian and another participant in the March 3 Dissenters’ March in St. Petersburg, said that she had supported the resistance to the putsch with all her heart. The only reason she did not join herself was having her first child.

“Of course, it was all terribly frightening, the putsch I mean,” Lena remembered. “But I saw the people who were involved before and after. Their faces were alive, that’s all I can say. Their eyes were bright. Look around you now at the faces here. People are awake. Look at the faces of the police. Completely dead.”

“That’s why I came here,” she said. “Of course I know it’s no use, that no one will pay attention. But I come here to feel myself a person, to feel myself honest. These elections were not honest.”

Asked if her daughter knows about the Putsch, Lena answered: “Of course, she’s aware of it all. Much more than the other kids her age are. She’s not here today, but I know she’s on our side. Her time will come.”

A risky undertaking? European insurers begin assault on Russia

Graham Stack for business new europe
With their advanced actuarial techniques enjoying huge demand in Russia as rapid growth leaves companies exposed to bigger and bigger risks, European insurance companies closed four major deals in 2007 in Russia – and opened up one bitter corporate dispute.

The shopping spree started in February, when globally-active Zurich Financial Services Group spent $260m to buy 66% in Russian retail leader NASTA. Only days later, German giant Allianz consolidated 97% of ROSNO by acquiring AFK Sistema’s 46.2% stake for $750m. In May, Allianz acquired 100% in Progres Garant for around $100m. The year ended on a high note with French major Axa buying 36.7% of RESO Garantia for around $1.2bn, a record evaluation for a Russian insurance company.

“I think there’s always been interest in the Russian market,” explains Alex Bertolotti of Standard & Poor’s about the breakthrough in 2007, “but once there was a big deal, which was between Zurich and Nasta, that opened the floodgates.”

Anastasia Voronkova of Fitch Ratings says the firms chose this year to move into Russia because of improved transparency in the sector as a result of efforts by the regulatory and supervisory bodies. “Then they saw high growth rates and also potential for future growth especially in the retail lines,” she says.

There is no mistaking the surge in the insurance sector. Against a backdrop of Russian GDP growth in 2007 of 8.1%, the highest figure since the turnaround year of 2000, the Russian insurance sector grew a whole lot faster than the economy: gross premiums written soared by 27% in the first nine months.

This growth has featured a major expansion of retail insurance, kick-started by the introduction of compulsory motor insurance in 2003, and by regulatory changes that put an end to the use of life insurance as a tax avoidance scheme, which cleared the way for life to start as a market segment with enormous untapped potential.

It is precisely the massive growth and potential of retail insurance that is attracting the attention of European majors. “They’re basically interested in retail, you can see in the companies they acquire they are focusing on retail lines, and in particularly motor insurance,” says Voronkova. “Foreign investors also demonstrate interest in the establishing of fully owned life insurance start-up subsidiaries, although this segment remains at a very early stage of development.”

“I think people are most interested in life, because there’s such huge untapped potential, with 144m people, relatively high incomes and very low penetration,” confirms Bertolotti.

Opinions differ as to whether 2008 will see similar deals. Voronkova believes “everyone is here who wants to be here,” but according to Bertolotti, “the trend will continue into 2008.”

Much-needed expertise

Foreign companies are not only attracted by growth, but by the problems that growth is causing for Russian companies – and to which they have the solutions.

The Russian insurance sector is young: only a few years ago did the sector begin to eradicate dodgy schemes and start to grow through real business. With the introduction of compulsory motor insurance in 2003, the companies had to establish new internal underwriting, claims handling, data processing and analytical procedures to cope with the sharply increased volume of contracts, information and staff, according to Fitch. Having established the infrastructure, the insurers are now challenged as to whether they understand the trends in underwriting performance and can forecast them.

This is where foreign companies have an advantage. “Russian companies need to improve everything, especially internal business procedures and loss ratios: they must use results of actuarial work more efficiently, detect sectors which drive loss ratios up, select risks more carefully using the results of actuarial reviews, which are more efficient in motor insurance,” says Voronkova.

“Foreign companies will deploy their marketing technologies, and also claims handling and analysis of loss trends with advanced actuarial techniques,” she says. “All these advanced techniques applied on western markets can be deployed on the Russian market to create a competitive advantage.”

S&P’s Bertolutti agrees. “The foreign companies will bring improved business practice, focusing on efficiency of claims processing, better underwriting techniques, and better use of actuarial techniques, because in Russian the actuarial profession is practically non-existent.”

Contemporary actuarial technologies are seen as the key to Russian companies coping with the risks of rapid growth, and in this area foreign companies are a universe ahead of even their biggest Russian rivals. “The workload of actuaries in Russian insurance companies is particularly intensive,” Fitch’s Voronkova says. “However, the role of actuaries seems to be generally underestimated.”

Voronkova argues that Russian companies tend not to employ actuaries in senior technical positions and thus fail to derive full benefit from actuarial skills.

Nevertheless, the sudden appearance of major European companies in the sector and the competitive threat they pose is causing Russian companies to step up their modernization. The clearest sign of this was the appointment on January 16 of top Dutch actuary Jacob Westerlaken as CEO of Rosgosstrakh, another of Russia’s largest insurance companies. “Rosgosstrakh hired Westerlaken because they did not wish to lag behind in terms of international technologies,” says Voronkova. “Of course Russian companies are trying to improve their business procedures, because with market growing and loss rations worsening, there’s no other way to manage underwriting profitability.”

Deripaska’s body-Czech

Against the rash of successful big deals, only an attempt by Italy’s Generali to acquire a stake in market leader Ingosstrakh via Czech private equity group PPF went badly awry. Majority shareholder, uber-oligarch Oleg Deripaska, appeared to resent the fact that his former partner Alexander Mamut sold his approximately 38.5% stake to the Czechs without asking him. In October, an EGM to which PPF was apparently not invited, unceremoniously diluted the stake to around 10% by a fourfold increase in equity.

The dispute remains unresolved. After a court decision in December ruled against the dilutions, the company charter was altered in January to restrict membership of the board to persons with Russian citizenship, experience in the insurance sector and with financial or economic training. The EGM scheduled now for March 3 will see if PPF will succeed in asserting their claim to three places out of nine on the board.

After a year of revolutionary changes in the insurance sector, it is perhaps reassuring that some risks remain the same.

Russian schools start switch from Microsoft to open-source software

Graham Stack  for business new europe

A Russian government initiative to switch Russian schools from using Microsoft products – licensed and unlicensed – to open-source software has entered its trial phase. Good news for Russia’s nascent IT industry; bad news for Microsoft.

Public outrage erupted across Russia in 2007 when Aleksandr Ponosov, head of a village school in Sepych, Perm region, was arrested for running unlicensed Microsoft operating systems on the school’s computers. He faced up to five years in jail until President Vladimir Putin spoke the magic words and the case was dropped.

Ponosov was widely seen as a scapegoat of US demands for a clampdown on pirate software, and the case was a public relations disaster for Microsoft in Russia. The political fall out may be even more troublesome for the global software giant.

Estimates that 70% of school software in Russia is unlicensed prompted the government to fund development and implementation of open-source software for public sector use, starting with schools. “It’s happening,” says Renaissance Capital’s IT analyst David Ferguson.

The first trial of Linux-based software for schools is in full swing – and it’s poetic justice that the trial regions include beyond Tatarstan and Tomsk, also the Perm region where the unfortunate Aleksandr Ponsov taught. Armada, one of Russia’s big-three IT companies won the trial tender in November, with a value of $2.7m for the company, and the free products developed have now marked their 10,000th download over a period of two months.

In November, no less a figure than Dmitry Medvedev, now president elect but then deputy prime minister, called for a move to open-source software across the board in the public sector, citing a host of convincing reasons: to eliminate pirate software while side-stepping the punitive costs of purchasing or leasing Microsoft products; to boost the local IT industry; and to avoid the security risks ensuing from foreign-origin closed-source systems. Medvedev set the goal of developing a Russian open-source operating system with a full suite of applications for all government services and administration by 2010.

That was good news for Armada, says David Ferguson. The company was spun off last year by media concern RBC, and earns 46% of its estimated $100m annual turnover from government contracts. In the case of the trial open-source software for schools, it has acted as an umbrella for an alliance of software producers. If the current trial goes well, Armada will be in pole position to run the national roll-out slated for next year, “which could add $20m to its revenues,” according to Ferguson. Ferguson sees another 10-15 companies in Russia’s under-consolidated IT industry likely to get a slice of the action.

Aleksandr Ponosov is also happy, for revenge is sweet. After the emotional trauma of the criminal case opened against him, business daily Kommersant broke the news in February that he has left school teaching for new pastures – promoting the use of open source software as a PR manager for the Armada project in Perm region.

Sberbank strikes back on Russia’s mortgage market

Graham Stack for business new europe

New Sberbank chief German Gref has pledged to boost the mortgage financing operations of Russia’s largest bank. He might succeed, thanks to the fallout from the US sub-prime crisis and increasing demand for mortgages in the regions.

With a 0.5-percentage-point cut in its mortgage products announced March 24 and a cut in consumer lending rates, Gref lent substance to his promises to end the bank’s hypertrophied lending policy. He can be sure of the Kremlin’s approval; only two weeks previously, on March 5, President Vladimir Putin publicly criticized Sberbank’s strategy. “Only 18.11% of your assets are from corporate clients, 52.1% from individuals, but you lend in equal proportions to both. So it follows you finance corporate clients out of individuals’ deposits. Why? Sheer laziness?” Putin asked rhetorically.

Gref knew the correct answer: “We should be working for the population, helping people with their needs: housing, purchases.” This admission was easy for him, since he had made the same argument throughout his years as economy minister, which ended in late 2007 with his appointment to head up Sberbank. Since then, he has attracted new talent from international investment banks and consultancies, and launched a review of Sberbank’s strategy that’s expected to see a shift to a more liberal lending strategy. The March 24 announcement is a step in this direction.

Answer to the apartment question

For all the general talk of retail lending, the heart of the matter is developing mortgage lending – a central reform policy launched under Dmitry Medvedev when he was first deputy prime minister, and one that’s set to continue when he assumes the presidency in May.

The Kremlin has homed in on mortgage expansion as the key to one of Russia’s oldest and most intractable problems, famously referred to by writer Mikhail Bulgakov as “the apartment problem,” where the problem is the lack thereof. Analysts estimate five new cities the size of Moscow are needed to bring per capita Russian housing space up to a Western European level.

Mortgage lending is in its infancy in Russia, but grew astronomically in 2007 by 140%, or $17.6bn, in nominal terms, to total $30bn at end of 2007. But it’s still an embryonic business. Mortgages only equal 2.3% of GDP, or $211 per capita, compared with 10-15% of GDP in Poland, Hungary and the Czech Republic. Only 10-15% of real estate in Russia is bought using bank loans, compared with an estimated 30-40% of deals in other Central and Eastern European countries. Total mortgage debt, an estimated 59 euros per capita, ranks among the lowest in Europe, ahead of only Ukraine, according to the European Mortgage Association.

Such under-penetration suggests that 2007’s explosive growth is set to continue. Moreover, according to Natalia Orlova, chief economist at Alfa Bank, the mortgage market offers the highest-quality loans of any market, delivering average non-performing loan rates of below 1% for mortgage portfolios.

The sub-prime crisis is bound to shave off some of that growth, says Alfa Bank’s real estate expert Brady Martin, because, “40% of mortgages were made available from money raised abroad, so the mortgage market will grow slower than the 140% of recent years.”

But Sergei Zharov, executive director one of the leading private mortgage lenders KIT Finance, plays down the effect on lending growth in Russia. “In Russia, there is simply a massive pent-up consumer demand for products ranging from fridges and televisions to mortgages for apartments,” Zharov told bne in December. “And the rate of default on mortgages is around 0.5%. Russians pay their debts – it’s part of the mentality.”

State banks take up sub-prime slack

However, the global financial turbulence has impacted on the structure, if not perhaps the volume, of mortgage lending. Alexander Semenyaka, head of the Federal Agency for Mortgage Financing, announced March 21 that 2007 had seen the state-owned banks Sberbank and VTB dramatically increase market share on the mortgage lending market, despite years of shrinking market share.

According to Semenyaka, speaking to the daily Vedomosti, at the start of 2007 Sberbank and VTB together had a share of 15% of the mortgage volume. By the end of the year, their share had reached 31%, with 10 large private banks holding around 33%. It was the smaller banks that surrendered market share over the year. Some 40% of mortgage lending at the start of 2007 was by banks outside the top 12. By the end of 2007, the figure had plunged to 25%. Regional and smaller banks experienced difficulties obtaining funding in the wake of the liquidity crisis and responded by cutting lending and selling their mortgage portfolios to state banks.

“The fast-growing private banks who pioneered many retail products and have been cutting inroads into Sberbank’s markets share in recent years are reliant on wholesale financing,” explains UralSib banking analyst Leonid Slipchenko. “But mortgage lending really requires long-term funds, and it is the state banks with their huge deposit assets that have these.”

Another trend in mortgage lending that began in 2007 is the shift in growth away from Moscow to the regions. Regional data suggest that mortgages were expanding in Russia’s regions in the second half of 2007. The share of mortgages issued in Moscow in the second half of 2007 dropped to 16.8% of the Russian total, against 30.2% in the first half. “Growth possibilities in Moscow are slowing as prices soar and more and more real estate is built by investors,” says Alfa Bank’s Orlova. Most notably in St Petersburg, the volume of new mortgages issued in the second city was almost twice that in the first half of the year, reaching 7% of the Russian total.

The jury is out on how these two trends – a relative strengthening of state bank lending and accelerating regional growth – will interact. Sberbank has not only better access to long-term financing than private banks thanks to its deposits, it also has a major advantage when it comes to competing for the regional market: an extensive network of branches. This explains why the mortgage market outside Moscow remains dominated by Sberbank, which issues 90% of its mortgages to the regions, with runners up UralSib 81.6%, Absolut 59.8% and VTB 56.7%. “Sberbank’s branch network is a huge advantage, and it could support their market share” says UralSib’s Slipchenko.

Will Sberbank under Gref build on the slight growth in mortgage market share achieved in the second half of 2007, or revert to its trend of declining share of mortgage and overall retail lending?

Natalia Orlova sees a lot of the regional growth being captured by the aggressive private banks moving out from Moscow to the regions, and is sceptical about lumbering Sberbank’s ability to control costs. Ironically, she sees Sberbank as more suited to work with corporate clients – for all that one might wish otherwise. “Gref was thinking more as minister of the economy than as CEO of the real existing Sberbank,” says Orlova of the latest Sberbank interest rate cuts. “After all, he’s new to the banking business.”

Gazprom’s Sochi: The Shtokman Field gas project moves towards implementation

On Feb. 21, the CEOs of Russia’s Gazprom, France’s Total and Norway’s StatoilHydro signed a deal establishing the Shtokman Development Company, a joint venture that will develop (but not own) the eponymous gas field in the Barents Sea. The timing was highly symbolic, ten days before the election of Gazprom’s Chairman Dmitry Medvedev as Russian president and ten days after lavish celebrations of Gazprom’s 15th birthday starring outgoing president Vladimir Putin.

The Shtokman project epitomizes Putin’s policy of combining state control over oil and gas with accelerated development. The deal marks a new frontier for the pivotal Russian gas industry firmly under Russian state control. The energy giant threesome formally established what had been agreed months ago. It is a special purpose vehicle that will develop the field while leaving the license in the hands of Sevmoreneftegaz, Gazprom’s 100 percent subsidiary. In contrast, Gazprom holds a 51 percent stake in the SPV. Total has 25 percent and StatoilHydro – 24 percent.

Gazprom comes up trumps

The creation of the Shtokman Development Company puts an end to a number of intrigues that developed over the past two years. In 2005, initial intense jockeying among foreign energy companies to join the Shtokman consortium resulted in a short list, comprising the Norwegian companies Statoil and Hydro, the U.S. majors Chevron and ConocoPhillips, and France’s Total.

Jaws dropped at Gazprom’s hubris in October 2006, when its CEO Alexei Miller declared that the company did not need any foreign partners to develop Shtokman, but would go at it alone.

Then, in July 2007, Gazprom relented and closed a deal with Total, which the Financial Times termed possibly “the worst a foreign oil company has ever accepted in Russia.” Gazprom retained full ownership of the field and the production license while gaining access to Total’s liquefied natural gas (LNG) expertise.Later the same year Norway’s merging Statoil and Hydro agreed to similar terms.

From the Russian point of view, there was poetic justice in avenging the humiliatingly one-sided Sakhalin PSA deals of the early 1990s. These had just undergone a major revision, and Gazprom been cut in on the deal following foreign company harassment by Russian state watchdogs.

In this case, the boot was on the other foot. The deal, which reduced Western oil and gas majors to the role of mere contractors, was seen as catalyzing the era where multinationals would only be able to access reserves in junior partnership to state-owned companies.

Gazprom’s subsequent announcement that all Shtokman gas would go to Europe (without the liquid natural gas supplies previously envisaged for North America) combined with the exclusion of US companies from the project, pointed to geopolitical considerations and caused further irritation.

But this year, the emotional reactions have given way to a calmer approach. Observers were pleasantly surprised to learn that the foreign partners will be able to book the field’s reserves – boosting a key market indicator of long-term economic health of the companies and raising their status.

“They were originally hoping for ownership rights, but it was pretty clear that they weren’t going to get these. They were allowed to book reserves, which surprised analysts. That makes them much more than just contractors,” USB Moscow analyst Dmitry Loukashov said.

“Basically, what the foreigners get from this project is booking reserves proportional to their stakes in the SPV, and secondly, they will be entitled to profits. They will have ownership rights only to infrastructure, not to the field itself or the gas produced,” said Constantine Batunin, an oil and gas industry analyst at Alfa-Bank.

According to French energy expert Pierre Noel, the same results could have been attained through a conventional contract with shared ownership of the field. He argues that the difference is symbolic, but the issue itself, he believes, is all about symbolism of who has the upper hand.

However, one crucial aspect for Gazprom will be far from symbolic. The deal means Gazprom owns the gas, and thus dictates the markets where it will be sold. This secures Russia the extra-economic leverage, the “soft power” it is demanding from its resource base.

The tip of the iceberg

Having decided who will own the gas when it comes on stream, the only outstanding issue is drilling 4,000 meters below an uneven seabed, 350 meters below an iceberg-ridden ocean 550 kilometers from the mainland.

“They simply do not know exactly how they are going to do this,” Batunin said. “Gazprom admits this openly. It doesn’t pretend to hide the fact. But they believe they can do it, and the deadlines are tight, with gas to go on stream in 2010.”

In 1988, when the Soviet Union discovered the sprawling gas field 550 kilometers northeast of Murmansk (on the Kola Peninsula), the super-giant field was estimated to harbor some 3.2 trillion cubic meters, in addition to around 31 million tons of condensate.

The unique features of the field meant that assistance from foreign partners was inevitable. It is technological expertise, and not financial resources or market access that determined Gazprom’s choice of partners.

“It would have been impossible to pursue a project like Shtokman alone both financially and technologically. Total has expertise in LNG and deep sea projects, and the Norwegian companies have expertise in the area, so for Gazprom it is about risk reduction and sourcing technology,” Batunin said.

“Frankly, it’s yet to be decided which technologies should be used for this project. It might not even be the Norwegian technologies. This is going to be an incredibly sophisticated project. All similar Norwegian projects are significantly less ambitious than this one, because the field is located very far offshore, and new technologies have to be created. These will be created on the basis of expertise that Statoil has, but they will be new.”

The project is mind-boggling. There are 565 kilometers of open sea between the Shtokman field and the onshore production facilities at the Barents port of Teriberka. A sea populated by icebergs and drift ice with sub-zero temperatures, polar nights, mega-waves and an uneven seabed. A total of 156 wells will be drilled to a depth of 1,900 to 2,300 meters below the sea floor. Four platforms will be built, and forty wells drilled directly from the seabed.

“Gazprom realized nobody would do this sort of job on a contractual basis,” says Loukashov. “The foreign partners will have more responsibility because of the technological demands.” Pierre Noel agrees that it was the technological difficulties that drove Gazprom to share risks.

But the main technological dilemma concerns the pipeline link to the mainland. Statoil managed to cover 160 kilometers from the pioneering Snovhit gas field to their liquid natural gas plant on Melkoya Island. Anything over that has never been attempted.

Is Gazprom up to the challenge? Politicized, bureaucratic and opaque, it would seem that the company is the weakest link in the Shtokman troika.

However, precisely by relegating foreign partners and taking most of the risk upon itself, Gazprom and the Russian government have turned the development of the Shtokman field into a prestige project – Gazprom’s very own Winter Olympics, substituting Shtokman for Sochi and symbolizing national revival. With the Russian penchant for gigantism and Gazprom’s chairman becoming president, this could mean there is too much hinging on the project for it to be allowed to fail.

Petersburgers underwhelmed by “Kinder Surprise” Medvedev

Graham Stack for business new europe

As universally expected, Vice Prime Minister Dmitry Medvedev, strongly backed by incumbent President Vladimir Putin and enjoying a lion’s share of media coverage, won 70.2% of the vote in the presidential election with almost 100% counted. Distant second came Communist Party candidate Gennady Zyuganov with 17.77%, followed by nationalist Vladimir Zhirinovsky with 9.37% and rank outsider liberal Andrei Bogdanov with just 1.2%.

Both Putin and Medvedev hail from St Petersburg, and the city shows the extent to which Putin has reshaped the Russian political landscape. Once a strong hold of Russian liberalism, with liberal parties like SPS and Yabloko taking 30-40% of the vote in the 1990s, now the pro-Putin United Russia party enjoys a majority in the city’s parliament, and liberals lead a marginal existence.

At the same time, St Petersburg has shaped the new Russian political landscape: Not only Putin and Medvedev, but the majority of Putin’s Kremlin team worked in the city’s administration in the 1990s.

Like Putin, 42-year-old Dmitry Medvedev, Russia’s new president, is a son of Russia’s cultural capital. He was born, grew up, studied and worked in the city until the Anatoly Sobchak administration in which Putin was vice mayor lost the municipal elections in 1996. Medvedev’s wife is also from the city.

However, this does not guarantee him the affection of his fellow Petersburgers, although his backing from Vladimir Putin guaranteed him their vote. Many on the historical streets of the city centre on election day March 2 were skeptical about Medvedev’s leadership qualities and mocked his lack of charisma. In voting for Medvedev, they did not vote for the person, but for stability, and for Putin.

“Yes, we voted for Medvedev, but we don’t like him” said Olga, 35, an architect, and her friend Masha, 27, agreed. “We’ve never seen much of him, and he doesn’t come across positively on TV. He’s wooden. I voted for stability, and because there’s no alternative to Medvedev.” Both also agreed: “We liked Putin much better, but the law rules out more than two terms.”

When asked if they considered Russia a democracy, they both laughed. “Perhaps in a relative sense,” said Olga. “We’ve a long way to go before we’re a democracy,” said Masha. But both are proud that the third Russian president is a Petersburger.

“I will vote for Medvedev because of Putin” said Leonara Kononova, 71, “but he hasn’t really done anything or said anything independently.”

Lena, 25, who works in radiophysics, said she had not decided who to vote for. For Lena as well, Medvedev suffers by comparison with Putin, “I don’t like the way he speaks – he can’t construct proper sentences. It’s always pleasant to listen to Putin speaking. He answers quickly and in clear sentences.” Lena’s biggest concern is the state of science in the country. “So many friends leave the country after studying to do their PhDs abroad. They get offered good grants and jobs.”

Almost all those voting for Medvedev would have preferred to see Putin stay – although, as most added, he is not exactly going either, since he is set to become prime minister. “Putin should have stayed,” said 24-year-old Svetlana, selling souvenirs at a stand. “We’ve got used to him.”

“No I don’t like Medvedev particularly, but Putin is staying anyway as prime minister, so it’s OK,” said 22-year-old Dima. “The main thing is for the authorities to observe people’s rights,” said his girlfriend Sascha.

“We’d have liked Putin to stay” said Marat and Kamilla, 22 and 21. Marat, a manager, added that, “the most important thing is that there is no default again.”

Some who support Putin voted or were considering voting against Medvedev. Tatiana, 55, a nurse by profession, said that she had voted for Zyuganov. “Medvedev is too young. What’s he ever done? He is like a Kinder Surprise.” But her sister Elena, a librarian, said she voted for Medvedev because of Putin.

Another pair of sisters, teachers Alexandra and Nastya in their mid-20s, said they approved of Putin, “who’s going to stay anyway,” but they had voted for Bogdanov, the long-haired outsider pro-EU candidate. “He’s an alternative kind of guy. They were showing Medvedev on TV all the time, it was unbearable,” said Nastya.

Ironically, however, most analysts agree that the Bogdanov candidacy was initiated by the Kremlin to increase the number of candidates. Alexandra and Nasty hoped for an end to bureaucratic arbitrariness in Russia.

Even a member of Edinaya Rossiya, 35-year–old neurologist Mikhail, had little positive to say about Medvedev’s personality. He said he thought it was good to separate politics from personality, and said he was simply voting for his party’s candidate. The greatest current danger he sees is for Russia to get “dizzy with success” and overplay its hand on the international stage.

Irina 62, was one of the few with something positive to say about Medvedev: “He is young and clever, and the partnership with Putin will be strong.”

Arkady, 32, a rock musician, was positive about Medvedev because of his taste in music – Medvedev is a Deep Purple fan. As to Russia’s international status, Arkady believed that “countries will start respecting us when we learn to respect each other.”

“Russia’s biggest problem is high prices for oil,” he said ironically, and no, he does not consider Russia a democracy.

The protest vote

Vyacheslav, a 70-year-old post office worker whose vote went to the Communist Party’s Zyuganov, is one of the few to offer sharp criticism of Putin. He was outraged by Putin’s recent statement that, “whether you like it or not, we need to raise the salaries of civil servants many times over.”

“He won’t raise pensions, but he brazenly declares he’s going to raise his own salary a number of times over, whether we like it or not!” Vyacheslav said that Russia is “at the most to be only 50% democratic.”

Alla, 55 years old, voted for Zyuganov because of his policy of nationalization of natural resources, a point mentioned by other communist voters.

Alexei, 18, said he intended to vote for anyone except Medvedev and the United Russia party, and had voted for nationalist Vladimir Zhirinovsky in the Duma elections in December. He pointed to inflation and pensions as the main problems in Russia, and also a lack of national pride.

The most damning criticism came from those who refused to vote, because they held the vote to be pre-decided. “It’s all a farce, it’s all arranged,” said 40-year-old engineer Yevgeny, who nevertheless speaks positively about Putin as honest and hardworking. “The country will only change when the relationship between people changes, when people start to think of others instead of just themselves,” he philosophised.

Sveta, 27, a doctor, and Seryozha, 45, a technician, were also not intending to vote, because they hold it all for a charade. They even denied that Putin and Medvedev had anything to do with St Petersburg. “They’ve been in Moscow for so long,” Seryozha said. “Moscow has swallowed them up like a swamp.”

Rosoboronexport / Russian Technologies – Russia’s unofficial ‘Ministry of Deprivatisation’

Graham Stack, for  Radio Free Europe / Radio Liberty

Defence sector restructuring into sector-based holding companies was on the cards right from the start of Vladimir Putin’s presidency. What is striking is that the plan to establish holding companies largely failed to get off the ground during Putin’s first term. Apart from the establishment of the Almaz-Antei tactical missile and Sukhoi aviation holdings, the 2002 project to set up 74 state-controlled concerns and holdings remained entirely on paper due to bureaucratic infighting, conflicting visions, and above all widespread resistance from enterprises. Then even the Almaz-Antei merger plan hit an iceberg when new Kremlin-appointed manager Igor Klimov died in a hail of bullets in Moscow.

Put simply, the reasons for consolidating individual plants into sectoral holdings were also the reasons why there was so much resistance against this happening: the managements of the defence plants, both state-owned and private, feared losing control of ‘their’ companies and the connected financial flows. However, without consolidation, and separation of ownership from management, these enterprises would remain unable to attract the financial resources they desperately needed to develop.

Wholesale renationalisation was still firmly off the agenda during Putin’s first term. Restructuring plans were mostly connected with further privatization – but there was no political will for this.

The stalemate ended abruptly in 2004. Putin’s radical reshaping of government on dismissing the Kasyanov government one week before reelection saw a Federal Agency for Industry emerge with a remit for the entire defence sector, headed by Boris Alyoshin, an ardent proponent of the holding policy with an aviation industry background. The newly-created Federal State Property Agency was run by a contingent of Petersburgers committed to transforming federal state unitary enterprises into joint stock companies.

Moreover, in the course of 2004, federal power was considerably strengthened at the expense of business interests by the Yukos case, and at the expense of regional interests by the post-Beslan transition to appointed governors. In addition, the surge in oil prices, and the start of Putin’s second and final term in office shifted economic policy away from long-term institution building to state-accelerated economic diversification aiming at short-medium term results.

Rosoboronexport: More than just an arms exporter

Most importantly, in mid-2004 Sergei Chemezov took over as head of state arms export intermediary Rosoboronexport (ROE). He had long recognized that the company’s control over arms exports gave it enormous leverage over the defence sector, that could be used to achieve restructuring ‘by the back door’.

Two competing arms export organisations had been merged into ROE right in 2000, immediately following Putin becoming president. By 2004, ROE had a monopoly of export sales, except for four companies with their own export licences – including the aerospace legend MIG. In 2005, ROE sold $5.2 billion worth of arms, about 85% of all arms sales. However, Chemezov set about lobbying for a complete monopoly on arms exports for ROE, which was granted in 2006.

Since the Soviet collapse, arms exports had been the lifeline of the Russian defence industry, the only internationally competitive sector outside minerals and mining. Russian state arms procurement died during the nineties, and only slowly revived under Putin.

Because ROE assigned export orders to defence sector plants, it enjoyed potential leverage over the sector. Adding to this leverage was the Soviet system of internal competition in the defence industry, whereby a number of plants had duplicated production to stimulate competition. This means that ROE often has a real choice between plants when assigning export orders.

In addition, surging defence procurement later in Putin’s second term now provides the state with further means of persuasion for recalcitrant companies. Chemezov has clearly been able to influence defence ministry order assignment to facilitate renationalisation of companies.

Apart from these political levers, ROE takes 5-15% commission on arms sales, which rose from 5.5bn in 2005 to $7bn in 2007, meaning the company has considerable cash flow.

On the other hand, the company is formally merely a federal unitary state-owned company, and as such subject to a large amount of bureaucratic supervision and regulation: answering directly to the Federal Agency for State Property, the Federal Agency for Industry, the Ministry of Economic Development and Trade, the Ministry of Energy and Industry, the Ministry of Defence, and the Military-Industrial Commission.

The Chemezov Code: Back to the future

This is where the person of 56 year old Sergei Chemezov plays such a crucial role. Chemezov is an official Friend of Putin, and has a direct line to the Kremlin. It is this personal relationship, in the final analysis, that allowed ROE to act as an unofficial ‘Ministry of Deprivatisation’ independent of the government.

Putin and Chemezov’s acquaintanceship goes back to the time as KGB agents they lived in the same apartment block in Dresden in the 1980s. When Putin moved to work in the Kremlin administration in 1996, Chemezov moved to work under him, and has worked for him ever since.

Chemezov was involved in industrial espionage against the West, and his interest in industry, and catching up with the West in terms of technology, permeates his activities today: Chemezov is an ardent proponent of developing high tech production to diversify the economy away from its reliance on commodity exports.

“Our mineral deposits,” said Chemezov, in an interview with news magazine Itogi, “are finite. There are few remaining undiscovered gas and oil deposits in Russia. And they are non-renewable. But high tech, including for military use, can be refined without end, and its price is stable and predictable, whereas oil has fluctuated from $8 to $60 a barrel in the last ten years.”

“A state of the art fighter jet costing around 50 million dollars: This is the price of two and half tonnes of gold. Russia produces 166-180 tonnes of gold per year, enough for 65 fighters. Our Irkutsk plant alone will turn out 32 Su-30s in 2007– i.e. worth half of the gold mined in the country in the course of the year!”

“Everyone knows that we have to get away from our country’s dependency on commodity exports. We have to diversify our industrial production. Reforming Russian industry is simply a question of national security.”

Chemezov thus shares with many liberals the view that Russia has to diversify its economy, increase added value, and become globally competitive. However, the means he proposes to use are very different, and potentially mutually exclusive. Instead of long-term institutional reforms, he favours a state-led restructuring and repositioning of the technologically advanced defence sector as being the key – a restructuring based on renationalisation of much of the sector.

Chemezov sees the defence sector as crucial in this respect because of its potential for economic diversification and high tech. Chemezov’s goal is globally competitive Russian high-tech production – both military and commercial, He is not a militarist intent on turning Russia into a military superpower again.

Chemezov does not seem to regard the West as an enemy, but he views Western companies as competitors on global markets, enjoying strong backing from their respective states, which Russian companies should thus also enjoy.

Indeed, Chemezov sees Western markets as a huge untapped potential market for Russian commercial high tech, and the West as a crucial source of both investment and technology. ‘Diversification’ thus also involves diversification from military use into commercial use technology to access western markets closed to Russian arms.

Cutting the Gordian Knot

Chemezov’s political trademark has been to cut the Gordian knot in defence sector restructuring by renationalizing.

Whereas in Putin’s first term, talk of restructuring the defence sector envisaged ongoing privatization, Chemezov has done the opposite: buying back assets privatized in the 1990s from private owners or the stock market. This is partly due to desire to reassert state control over the sector, but also because it is simply the path of least resistance for restructuring the sector.

Inefficient and unstable insider ownership by management, often via complex cross-ownership of companies by their subsidiaries, was clearly throttling the development of the sector.

In many cases, management control of enterprises depended on the state as a minority shareholder playing a passive role.

However, when political will appeared, it was easy for the state to unseat management, simply by increasing the retained minority stake to a controlling one by ‘market methods’: by acquiring free-float shares; buying out private investors and management-owners or implementing asset swaps for ROE assets, especially with regional government stakes.

This is what ROE and its subsidiaries have set about doing, with the cooperation of further state instances, such as the Federal Agency of State Property.

Many of the plants ROE has taken control over had low market capitalization, so relatively small cash payments have been needed, especially where the state retained a share packet. For instance, to reassert state control over the famous Moscow Milya Helicopter Plant, all it took was to acquire the 20% stake held by Interregional Investment Bank for a mere $20m. The Tatarstan regional government was persuaded to simply swap its 30% stake in Kazan Helicopter Plant for 15% in ROE subsidiary Oboronprom.
ROE has acted with a minimum of publicity to avoid driving up prices of assets it wants. Secrecy has been a hallmark of its activities, in keeping with the KGB background of many of its managers, with the ‘unofficial’ nature of ROE’s restructuring activities. This means that the details of many details have remained unknown.
Vertical take-off for renationalisation

Only three weeks after Putin’s reelection in March 2004, Boris Alyoshin, as new head of the new Federal Agency for Industry, submitted a project for ROE subsidiary Oboronprom to unite all companies developing and building Mil-class helicopters in a special holding. This remit then broadened into creating a holding for all Russia’s producers of helicopters.

Oboronprom is the vehicle used by ROE to piece together its helicopter, and aviation engine, holdings, originally 51% state owned, 49% state owned. Its youthful former manager, 38 year old Denis Manturov, promoted in 2007 to deputy minister for industry and energy, enjoys Chemezov’s full trust, and is rumoured to be a former intelligence service colleague, who however had been working in the helicopter sector for almost ten years.

At the start of the process, the state had retained at the most blocking stakes in Russia’s main helicopter producers. The main producer of attack helicopters, Rostock helicopter plant (Rosvertol), was completely private, controlled by its management, and the legendary Kamov holding was owned by financial-industrial group AFK Sistema.

This is where ROE came into play, with the task of creating a holding ‘outsourced’ to the arms trader. In the predominantly state-owned plane-building and ship-building sectors, consolidation into holdings was official government policy. Helicopter sector consolidation, on the other hand, was ‘unofficial’ policy since it comprised large-scale renationalisation.

It was also a test case for renationalisation “by market methods”.

2004-2007 Oboronprom worked hard at gathering the helicopter industry under one roof. It acquired 31% of the Milya Moscow Helicopter Plant, 29.9% of the Kazan Helicopter Plant, 63% of Ulan-Ude Aviation Plant, 60% of the Stupino Machine Production Plant and 50.5% of Vpered Moscow Machine-Building Plant, and bought first a blocking, then a controlling consolidate a controlling stake in Rostvertol. It purchased from AFK Sistema 100% of the shares of Kamov-Holding, including the Kamov Design Bureau and the Kumertau Aircraft Building Plant and Arsenev Plant.

Integrating the major Kamaz Helicopter Plant (KVZ) proved to be the greatest political challenge, due to resistance from management owners backed by Tatarstan’s government. Only after President Shaimiev’s reappointment by Putin, wielding his new powers, in 2005, did Tatarstan cede its 29.92% stake to Oboronprom in return for a 15.7% stake in Oboronprom. It was not until 2007 that Oboronprom finally bought out the management stake, resulting in the abrupt departure of KVZ’s director of 17 years standing, its chief owner, and opponent of Oboronprom, Aleksandr Lavrant’ev.

The icing on the cake was an August 2007 presidential decree transferring the state’s stake in Bashkiria’s Kumertau plant and in the ‘Progress’ plant that produces the ‘Black Shark’ attack helicopters to Obronprom.

The operation was accomplished without any public scandals breaking out or overt pressure applied, and to the general satisfaction of stock market analysts. Oboronprom could thus call itself a model of how to create a state-run holding from out of privately-owned defence enterprises.

Oboronprom’s helicopter assets are now being integrated into a single company called “Russian Helicopters.” A new phase of integration was launched at the start of February, 2008: the management of Russian Helicopters took over running the Moscow Milya Plant, with the same to happen for all other companies in the holding in the course of the year. The goal, by 2010, is a single share, international accounting standards, and an IPO, leaving the state with just over 50%, and bringing in foreign investors.

On the same day in August 2007 that Putin signed a decree transferring the remaining state assets in the sector to Oboronprom, he inked a decree calling for four state-controlled holdings for producers of aviation engines.

This decree specifically tasked Oboronprom with setting up the largest of the holdings. The three other holdings comprises state-owned companies, but Oboronprom’s holding was to integrate the Saturn plant in Rybinsk, Ufa’s UMPO and Perm Motors – all of which are privately-owned companies.

Analysts regard Saturn as an exemplary thriving management-owned company, with large investments in R&D and retooling making it the technologically most advanced company in the sector. Saturn, in partnership with Snecma, a member of France’s Saffran aerospace group, developed the SaM-146 engine to be used for the much-hyped Sukhoi Superjet 100.

However, despite these services, first deputy chairman of the Military Industrial Commission Vladislav Putilin stated unambiguously, commenting the presidential decree: “Oboronprom must take control of companies where there is currently no state control.”

Titanium tempation

ROE has also taken control of plants in the metallurgy and mining sector it believes to be of strategic importance for the defence sector.

In late 2006, ROE subsidiary OboronImpex acquired 66% of Russian titanium producer VSMPO Avisma, which as supplier of 65% of Airbus titanium needs and 30% of Boeing’s has strategic significance for the global aviation industry.

VSMPO- Avisma, the result of a merger in 2005, had a rocky history in terms of ownership, with an ongoing dispute between Renova and Renaissance Capital over a 13.4% share packet. Soviet era management held a controlling stake, with 73 -year old general director Vladislav Tetyukhin and chairman Vyacheslav Bresht each with 30%.

In an interview with Vedomosti in February 2008, OboronImpeks director, the 40 year old Mikhail Shelkov said “ROE entered VSMPO Avisma and (car producer) AvtoVAZ for the same reason. Both companies are strategically important for the economy, and both had problematic ownership structures. At VSMPO there was a conflict between Tetyukhin, Bresht and Vekselburg, and the company was suffering.”
Chemezov has also argued that VSMPO-Avisma’s dependency on Boeing and Airbus meant there was a great risk of the company being acquired by foreign aviation concerns, to the disadvantage of Russian plane producers.
The real reason may have been to increase Russia’s leverage over Boeing and over Airbus producers EADS in order to deepen collaboration and technology sharing. Ultralight titanium components are crucial to the new generation of airliners, such as Boeing’s Dreamliner and EADS’s next generation Airbus – and global titanium supply is stretched. Both companies depend on Russia for supplies – and Russia depends on them for technologies and partnership.

The ROE takeover has thus strengthened the titanium producer’s partnership with Boeing. In August 2007, VSMPO Avisma formalised a joint venture with Boeing, Ural Boeing Manufacture (UBM), to manufacture components for the Dreamliner. Pressed titanium components made by a new UBM plant in the Urals, with startup slated for late 2008, will then be finished at a Boeing factory in Portland, Oregon. UBM will also supply titanium components to Airbus.

Oboronimpeks management claims the new owners have brought order to the plant implementing SAP for most business processes. A $1bn investment programme is intended to diversify production by 2012 and increase its added-value, ending production of titanium sponge in favour of higher-grade titanium ingots and also milled products. Market capitalization has grown following the company’s renationalisation.

In autumn 2007, the ROE acquisition conveyor belt started moving again – into mining. Citing a shortage of carnalite used in titanium production, ROE’s subsidiary OboronImpex acquired Kama Mining Company on parity basis with Silvinit. The JV plans to acquire a licence to develop the Polovodosk potassium and magnesium salt deposit, and to built a $1.5bn plant to supply VSMPO-Avisma on an exclusive basis with 500,000 tonnes of carnalite annually. It was also reported at the end of 2007 that ROE had engaged British-owned mining concern Aricom, a subsidiary of Peter Hambro Mining as advisers to help them develop mining assets.

The move into mining is indicative of the way ROE’s core business of weapons exports seems to effortlessly pan out like spilt beer across a table – from defence export, to producers, to metallurgy, to mining. There was thus little surprise when in early 2008, it was reported that ROE was laying claim to a 49% Russian state stake in Mongolian company Erdenet, Asia’s fifth largest copper producer.

ROE has not just staked a claim on exotic ultra-light materials like titanium. ROE started targeting ‘special steels’, i.e. high grade steels suitable for use in armour and other defence applications, in 2007. The vehicle for this is a specially created holding RusSpetStal holding, 100% owned by ROE. Its first acquisition was 100% of the Krasnyi Oktyabr metallurgical plant in Volgograd early in the year, and a couple of more minor purchases followed

Even Chemezov sometimes loses track of all he is after. Speaking at the Paris Airshow at Le Bourget in June 2007, Chemezov said RussSpetsStal had approached the Kulebaki metallurgical plant, the Volgograd machine-building plant, and Stupino Elektrostal plant. But this, Chemezov said, was by no means an exhaustive list. “In fact, I cannot even remember them all,” he admitted.

Saving private AvtoVAZ

Most controversially, ROE took control over giant car producer AvtoVAZ, based in Tolyatti in Samara region, in 2005, and analysts rubbed their eyes in disbelief at seeing the state arms exporter intervene in domestic car production.

A new ROE management team quickly took over running AvtoVAZ, replacing 65 year old Vladimir Kadannikov who resigned, apparently after a meeting with feared Kremlin deputy chief of staff Igor Sechin. The new management came backed by battalions of police dispatched from Moscow to eradicate of organised crime from the plant.

The car giant AvtoVAZ, valued at $2.270bn, with a workforce of 165,000 producing about half of Russia’s needs in passenger vehicles, was adrift in dire straits, with rapidly receding market share, as imports flooded into Russia.

The AvtoVAZ plant, ever since late Soviet days, has been a feeding trough for organized crime, with a death toll nearing 100. The new AvtoVAZ’s first task, apparently successful, was to put an end this. Chemezov claimed that in one year the new management was able to cut costs by almost a third and increase profit by 40% year on year simply by ending crime and theft.

Furthermore, a cross-ownership share structure crippled management incentives: Kadannikov controlled the plant without owning it. This structure also made it easy, given political backing direct from the Kremlin, for a new management team to come in and take over, with the aim of “unlocking” cross-ownership and attracting external investors.

Two years later, cross-ownership is on its way out, and will be wound up by June 2008, facilitated by the technical expertise of investment bank Troika Dialog, ROE’s partners of choice. Share price has spiralled, but not profits or sales.

In the course of 2007, a number of personnel changes cemented ROE’s role in AvtoVAZ’s future. Most notably, Putin appointed the new AvtoVAZ CEO Vladimir Artyakov, a close associate of Chemezov, governor of the wealthy Samara region. Boris Alyoshin, head of the Federal Agency for Industry, then took over as general director of AvtoVAZ.

2008 will see AvtoVAZ’s reanimation move onto a new level. In December 2007, AvtoVAZ and Renault signed a memorandum of understanding declaring the intention to “to renew the lineup, exchange technologies and promote the Lada brand.” Renault is likely to pay over $1.3 billion for a blocking stake in AvtoVAZ.

In February 2008, it was declared that Carlos Ghosn, CEO of Renault would join AvtoVAZ as chief operating officer, with members of his Renault team becoming CFO, managerial accounting director, product planning director and chief engineer: the same team that turned around Nissan’s operations effectively.

Raiders of the lost rotorcraft

Vladimir Putin signed off November 26th 2007, on a bill setting up a state corporation Russian Technologies, to be headed by Chemezov, Two days later Putin signed a bill transferring ROE and all its assets to the new corporation, and ordering the government to draw up a list of further state assets to be transferred.

One week later, hitherto unknown businessman Oleg Shvartsman gave an interview Kommersant business daily that detailed his role in a dirty tricks campaign that was an integral part of renationalisation “by market methods’.

Shvartsman described the renationalisation crusade as a state-sponsored ‘velvet revolution’ aiming in particular at defence-related enterprises. In language reminiscent of Chemezov’s, he called this “a state task to develop the innovation sector, to transform Russia from a raw materials producer into a progressive innovation power”. He also claimed to have been acting under direct orders from the Kremlin hawks known as ‘siloviki’, to which Chemezov belongs.

Much of the credibility of what Shvartsman said comes its strong fit with observable trends:

“Generally we use voluntary-compulsory instruments to lower market capitalisation, by blocking growth, and using all sorts of administrative methods,” Shvartsman explained in the interview. “But, as a rule, people understand where we are coming from. In fact, usually we are talking about conflicts that are already smouldering somewhere, already the centre of attention for existing companies. They only need to come to an arrangement with our older colleagues and reach some sort of agreement. As a rule, it is the lower rung of the market value. But we’re not talking about another YUKOS case – the people do get reasonable money.”

The impact of the Shvartsman interview was due to its plausibility, as many commentators observed. The ROE deprivatisation campaign features use of ‘administrative resource’ , i.e. law enforcement and tax organs, and courts, to exert pressure on recalcitrant owners – and these are only the rare cases that come to light.

In August 2007, long before the Shvartsman scandal broke, Konstantin Makienko of Moscow’s Centre of Analysis of Strategies and Technologies (CAST) wrote baldly that “basically the story of the nationalisation of VSMPO Avisma and plane producer Irkut and of the helicopter producers shows that if the state takes a fundamental decision to restore control over specific assets, this will happen, sooner or later. Private owners display two reactions to nationalisation. The first is the “Tetyukhin reaction”, the second the “Bresht” reaction (the two former majority shareholders of VSMPO Avisma). The first reaction offers to cooperate with the nationalisation plans, as a result of which the owner retains a management position, a small share packet and financial compensation. (…) The second reaction leads to the private owner or his close relatives finding himself in trouble with the law enforcement organs, and ultimately his share packet reverting to the state and him being forced out of the business without adequate compensation.”

An obvious instance of such pressure while buyout negotiations were under way in 2006, was, for example, that tax inspectors suddenly filed back tax claims against the company. A judge handling the case expressed perplexity at how Avisma might be credited with R10.6m of tax overpayment on March 13, 2006, and then, out of the blue, significant tax arrears all of two weeks later.

However, analysts agree that in the case of helicopters producers, ROE did not employ much coercive pressure, since it already had strong levers of influence through control of export orders and state procurement. According to analysts, not only foreign export orders, but also state procurement orders stopped going to companies with less than 50% state ownership.

Yury Lastochkin, owner-manager of the Saturn aviation engine producer, is publicly resisting renationalization, as demanded by the August 2007 presidential decree on setting up state-owned holdings for engine plants.

As a counter move, Lastochkin is pursuing a voluntary merger with Ufa’s UMPO, while stalling on talks with Oboronprom. He argues that this fulfils the spirit, if not the letter, of Putin’s decree. When, however, Kommersant asked Denis Manturov if he agreed with this interpretation, Manturov called Lastochkin’s position ‘destructive’ and said threateningly, ‘I advise Mr Lastochkin to read what is set down black on white in the presidential decree about who is to do what and when.” He stated Oboronprom would ultimately require 100% control over Saturn, although the state’s current stake is 37%, with management holding 57%.

The conflict escalated in late December 2007 with Saturn’s purchase of 20% of UMPO, and start of buyout talks. Lastochkin told Vedomosti that state ownership was irrelevant. “The state already has all the levers of influence it needs. The main thing is the efficiency of the consolidated companies being created.”

In the same interview, Lastochkin discussed the fact that the Yaroslav regional section of pro-Putin party Edinaya Rossiya ‘only’ took 53% of the vote in the December 2 Duma elections, 11% less than the national average. This caused Yaroslav governor Anatoly Lisitsyn, a Lastochkin ally, to resign days later. Lastochkin is himself a member of the regional party council, demonstrating how entwined the “Putin party”, the economy and the state are becoming.

Saturn is Russia’s largest and most technologically advanced aviation engine maker, with a workforce of 40,000. Lastochkin said stingingly that “to hand over assets we have been developing and structuring for over 10 years to complete nobodies is beyond a laughing matter.”

Asked by the interviewer if he did not fear law enforcement or other state agencies would attack the company’s market capitalisation a la schvartsman, Lastochkin hoped the state would be clever enough to avoid such “experiments” that could disrupt the finely-tuned process of designing and producing advanced technology.

An second major headache for Oboronprom in setting up the engine-producer holding is the case of Motor Sich, the Ukrainian plant that supplies 80% of Russia’s helicopter engines, and 80% of Motor Sich production is exported to Russia. Oboronprom has held acquisition talks with Motor Sich, but they were broken off without results in August 2007.

Referring to Ukraine’s Nato membership bid, on February 5, 2008, Industry and Energy Minister Viktor Khristenko called for future substitution of Motor Sich imports by Russian-produced equivalents. 80% of Motor Sich components come from Russia.

Many analysts agree that the immediate motive here was to attack Motor Sich’s capitalisation and facilitate a Russian buy out: duplication of production would costg $300m-400m and take 5 years.

Immediately following the announcement, Motor Sich shares lost 14% of their value. One week later, Denis Manturov, former Oboronprom CEO, now deputy minister of energy and industry, again proposed that Motor Sich join the future Russian state holding.

Russian Technologies: L’etat, c’est moi

In June 2007, Sergei Chemezov first publicly spoke of fitting ROE a new legal status, “disposing of the full legal rights of an integrated economic subject, plus the rights of state procurement for certain types of military exports. Something between a unitary enterprise and a joint stock company.” He referred surprisingly in this context to the ARKO agency set up in 1999 to restructure banks following the 1998 financial crisis. Specifically for this purpose, a peculiar legal form called “state corporation” was created in 1999 as a non-commercial organisation, and had since fallen into disuse.

Putin, in his state of the nation address in April 2007, mentioned setting up a state corporation for the nuclear sector. However, it was assumed this meant a state-owned joint stock company analogous to the United Aircraft-builders Corporation or United Ship-builders Corporation created 2006.

It turned out that ‘state corporation’ meant precisely ‘state corporation’ as legislated for in the obscure 1999 amendment to the 1996 “Act on Non-commercial Organizations”, and mentioned nowhere in the Civil Code.

‘State Corporation’ (SC) went on to become the hit of the year, with SCs being founded for nanotechnology, Winter Olympics, housing reform, road building, the entire nuclear sector, both military and civilian – and for Russian Technologies (RT), aka Rosoboronexport: with its purpose defined as assisting the development, production and export of high-tech industrial production by supporting Russian organizations on domestic and foreign markets, and attracting investment to different industrial sectors, including the defence sector.

Nowhere in the special law on setting up RT is there any definition of what constitutes high-tech production. In this way, RT has carte blanche to intervene in any sector of the economy.

RT will also perform state functions “in the implementation of the state’s export and import policy and state policy concerning military-technological cooperation with foreign states. The list of functions can be extended by other acts or presidential decisions.”

In fact, the whole ‘state corporation’ concept is riddled with anomalies that create huge accountability and corruption issues:

Bizarrely, a “state corporation”, as laid down in the law, is neither state-owned nor a corporation: it is a non-commercial organization established by the state for a specific purpose – social or “managerial”. It is, however, not owned by the state. Property transferred to the SC belongs forthwith to the SC, and the state has no further claims to it.

An SC is strictly speaking not for profit, but there is a lot of leeway allowed; any profit it makes must be reinvested towards the purpose for which it was created, which however is vaguely defined. Similarly, an SC can act entrepreneurially if this serves the goals for which it was established.

In contrast to federal unitary enterprises such as ROE, SCs have the right to borrow domestically and internationally, to issue bonds and give guarantees. A SC can also establish joint ventures and other partnerships with the private sector.

On February 20, 2008, the Russian Federation Council published a devastating critique of SCs as part of its annual review of federal legislation. Among the points listed were: There is no restriction placed on the purpose and function of SCs; property and funds transferred to the SC become its property and the state has no further rights or claims on them; each corporation is regulated by a separate law, meaning they exist outside any unified legal framework, in a legal grey zone.

Most significantly, according to the Federation Council report: the law contains virtually no control over the activities of SCs. There are no evaluation criteria for SC goal fulfilment; no procedures for medium or long term planning; no sanctions for non-fulfilment of goals.
Astonishingly, considering the ROE story has been all about bring the defence sector back under state control, SCs are explicitly freed from all government oversight and intervention, excepting the power of the president to appoint management and supervisory board.
As stated above, SC assets do even not belong to the state, which makes a mockery of the ROE mantra of ‘bring defence assets back under state control’. In order to transfer ROE to Russian Technologies, it will be de jure privatised. In preparation for this, the state arms export monopolist was removed from the list of strategic state-owned companies in late 2007.
The Federal Council report concludes that SCs create “the perfect chance to transfer state property to the non-state sector with no financial benefit for the state and at the risk of uncontrolled use and alienation of assets.”
Less diplomatically, Kommersant wrote in December 2007, referring to the fact that SCs are formally non-profit organizations, that 2007 had seen “a $20bn donation to charity by the Russian state, the largest ever in human history.”

In fact, the complete lack of government oversight apart from presidential appointment, combined with far-reaching rights of disposal over assets, means that Chemezov’s claim to have restored state control over strategic assets only holds water if he claims ‘l’etat c’est moi’. Given the personalisation of power and property that has taken place under Putin, this claim would not be far from the truth.

There has been no government explanation for such wide use of the SC legal form in the last few months of Putin’s presidency. Chemezov has adduced a couple of reasons: that taking ROE outside the state allows him to pay managers a market-level salary, and that it reduces risk of US sanctions applied to ROE affecting ROE subsidiaries, which will probably now be transferred to direct ownership by RT.
These reasons hardly justify the sweeping and unsupervised disposal of property, and coercive power over whole swathes of the economy, that Chemezov will now enjoy.
However, it could be much worse. Even Chemezov has not seen all his wishes come true. He originally lobbied for ROE to implement the state arms procurement programme, which would have given him control of around $20bn revenues per year, turning RT into a Gazprom of the defence sector, but with even less accountability. This proposal was excluded from the RT bill. However, it is still open for the future – along with the option of transfer to RT of the state’s controlling stakes in the United Aircraft-builders Corporation and the United Ship-building Corporation.
Chemezov has until now worked mostly to nationalise private business, but the establishment of RT indicates he is increasingly set on privatising the business of state. The extent he achieves this under a Medvedev presidency will be a test of whether the incoming president’s public commitment to liberalism holds any water, and whether he can break with his predecessor.

Back to the future: The Kremlin takes control of Russia’s aircraft producers

By Graham Stack, for Radio Free Europe / Radio Liberty

Diversification of the economy has long since been a watchword for Kremlin officials. During Putin’s first term, the path to diversification was seen as the institutional reforms drawn up by German Gref’s Ministry of Economic Development and Trade. The state’s task was to establish an institutional framework supportive of diversification.

During Putin’s second term, soaring oil prices made diversification an issue of concern for Kremlin hawks as well as liberals. The former saw it as a matter of national security, that had twice over twenty years been compromised by sharp drops in the price of oil. However, their commitment to patient institutional reform was less marked than for the liberals.

At the same time, the financial resources accruing to the Russian government encouraged a pro-active policy towards industry and investment. Kremlin power increased respective to business interests as a result of the Yukos affair, and respective to regional interests as a result of the post-Beslan transition to appointed regional governors, expanding policy options.

Kremlin hawks and industrialists argued that Russia was already diversified, possessing a hi-tech defence sector and also civil aircraft construction sector that were still widely state-owned, and only just recovering from the collapse and chaos of the 1990s. The then defence minister Sergei Ivanov and the head of the state arms exporter RosOboronExport, Sergei Chemezov, among others, argued that diversification could be achieved through activating this resource. They advocated state-driven restructuring of the defence / aviation industries in connection with a rearmament programme making good for a decade of minimal arms purchases combined with an aggressive export strategy.

Defence sector privatisation: Disaggregation instead of rationalisation

The privatisation of the defence sector in the 1990s was a major political feat for reformers. There was an intrinsically political element to the way privatisation broke the sector up into its myriad individual component enterprises: reformer saw this as putting an end to the reactionary political lobbying power of the ‘military-industrial complex’.

Privatisation disaggregated the sprawling defence sector, but did not rationalise it. This was partly a result of the structure of the Soviet defence industry: for instance, design bureaus and production facilities were mostly separate entities, and the Soviet system of internal competition meant that many of the new semi-privatised defence companies duplicated each other’s production lines.

Furthermore, due to political backlash against privatisation and increased attention to strategic concerns, privatisation remained only partial, with the state retaining controlling or blocking stakes in almost all corporatised defence companies. Defence companies regarded as strategically vital and / or financially unviable remained in 100% state ownership as Federal Unitary State Enterprises (FGUP).

Combined with the general economic collapse, this meant that the defence and also civil aircraft construction sectors mutated into a sprawling archipelago of companies languishing in a limbo between state and private management. Since the state remained the single main owner of the defence sector, it was predestined to become the main actor driving on its restructuring, as soon as the necessary political and financial resources materialised.

Aircraft builders in post-Soviet Russia

Military aviation, in particular Russian fighter jets such as the Su flanker jet series and the MiG fighter jets, constitute Russia’s only globally competitive hi-tech production. Key enterprises such as Sukhoi, MiG and Irkut survived the 1990s by exporting their planes to non-Western countries. With an economic revival now well underway, the state procurement budget is now starting to play an important role again. But this does not compensate for the fact that Russia’s most technologically sophisticated and competitive production is barred from the enormous Western markets for obvious strategic reasons.

Russian civilian aircraft production, on the other hand, was devastated by the economic collapse of the 1990s, failing to compete even on the domestic market. To the insult of a massive collapse in demand was added the injury of Soviet production being outcompeted by Western models far cheaper to operate and compliant with international requirements. Not only did Russian and CIS carriers stop buying Russian planes, they actively started to phase them out especially on international routes, discarding their Tupolevs and Ilyushins for Boeings and Airbuses.

However, along with economic revival, passenger numbers are increasing 8% per year, generating demand for new, modern planes from Russian carriers. In a huge country like Russia, plane travel is quickly becoming again the dominant means of medium and long range passenger transport, and it is also a matter of national pride that Russian planes fly in Russia.

Setting up the UAC: Policy

Extrapolating from these structural conditions, and manifold policy statements, the Russian government’s goal in setting up UAC was to restructure and rationalise existing capacities in order to leverage this strong domestic demand (commercial and military) to produce globally competitive planes.

A key idea was to combine military and civillian production – separated in Soviet times – in one holding to create synergies and commercial spin-offs of military technology. The focus of the UAC is firmly on creating competitive commercial aircraft. There is thus a double diversification involved – from commodity export to high-tech production, and from military production to commercial.

The presidential decree on setting up the United Aircraft Corporation (UAC) was signed February 2006. The decree called for the UAC to be set up in three stages, the first stage being the establishing of the holding’s capital from the state’s shareholdings:100% of Sukhoi Holding Company (which owns 50.1% of the Sukhoi design bureau, 74.5% of the Komsomolsk-on-Amur KnAAPO plant, 74.5% of Novosibirsk’s NAPO plant, 11.63% of the Irkut Corporation, 38% of Beriev design bureau and 87.9% of Sukhoi Civil Aircraft); 25.5% of KnAAPO; 25.5% of NAPO; 86% of MAK Ilyushin (which owns 81% of Ilyushin Company and 30% of Voronezh-based VASO plant); 90.8% of Tupolev (which owns Tupolev Design Bureau and 73.5% of the Ulyanovsk-based Aviastar-SP plant); 38% of the Sokol aircraft plant in Nizhny Novgorod, 38% of Ilyushin Finance (IFC) leasing company; 58% of Finance Leasing Company; and 15% of the Aviaexport foreign trade company.

38% of the Irkut company was contributed by Irkut management, in return for a stake in UAC. The state was to own 90% of UAC.

Setting up the UAC: Politics and actors

A lot of the groundwork for setting up a consortium of aircraft constructors was performed ‘from below’, by companies themselves, especially by the managers and shareholders of the Irkut concern, such as Alexei Fyodorov, president of Irkut and owner of ca. 18% of the company. Fyodorov’s success in managing Irkut led to his being named head of the state-owned MiG and charged with turning the company around. Closely associated with Fyodorov was another Irkut manager and shareholder, Valery Bezverkhny, who became head of the non-commercial partnership United Aircraft Consortium, set up in 2005 without state involvement to coordinate sectoral activities, and which lobbied for sectoral consolidation through privatisation of the state’s shareholdings.

The subsequent success in establishing an aircraft producers’ holding thus owes a lot to its organic nature. However, these initial efforts were also a victim of their own success. State actors, mainly Defence Minister, and later First Deputy Prime Minister Sergei Ivanov, a possible successor to Vladimir Putin as president, Sergei Chemezov, head of state arms export Rosoboronexport, and Boris Alyoshin, head of the Federal Agency for Industry, hijacked the idea, and turned it into a vehicle not for privatisation of state shares in defence companies, but for consolidation of state assets in a state-owned holding, and, where necessary, deprivatisation of private owners. This move towards governmental creation of ‘national champions’ also fitted telegenically into Ivanov’s heightened profile as potential presidential successor.

This ironically made the position of the Irkut management, who had initiated the push for consolidation, precarious. Irkut was commercially by far the most important company in the sector, with sales figures for 2006 matching those of MiG and Sukhoi combined, and comprising half of the total order book for the entire Russian aviation sector.

Moreover, Irkut was a public company that had even conducted an IPO in 2004. Post-IPO the management stake had dropped from 70% to 44%. 32% was held by institutional and private investors. The state only retained 12% owned by the state-owned Sukhoi holding. A 10% stake in Irkut was held by the European aerospace champion EADS. EADS thus held only a slightly smaller – but more direct – stake than the Russian government did – in Russia’s most successful military aviation company.

Irkut management said as late as July 2006 that they expected to receive as much as 30-40% in UAC in exchange for their 38% stake in Irkut – since their consent was crucial to the UAC going ahead. However, to general surprise, state officials valued the Sukhoi Holding at $2-2.2bn, аnd Irkut at a mere $940m, despite the company’s having a market capitalisation of $1.12bn and outstanding financial results. As a result of what was widely regarded as a deliberately depressed evaluation, Irkut management were entitled to less than 10% of UAC for their 38% of Irkut – ensuring the state would own over 75% of the holding, securing it control.

Irkut management owners consented to this evaluation, since the government coopted Alexei Fyodorov, owner of 18% of Irkut, and Bezverkhnyi by appointing them head and deputy head of UAC respectively. At the same time, fraud charges were brought against another of Irkut’s owners and board members, Sergei Tsivilev who was apparently less willing to cooperate. The charges were immediately dropped on the deal going ahead, pointing to their being politically motivated.

Having acquired Irkut management’s 38%, UAC submitted a binding offer to Russia’s Federal Financial Markets Service (FFMS) on the buyout of Irkut 49.9% of Irkut charter capital, which was finalised in March 2008. Negotiations with EADS, owners of a 10% stake in Irkut, resulted in EADS agreeing to convert its stock into UAC shares (see below). This clears the way for UAC to switch to a single share with Irkut in 2008.
Currently the process of the putting the UAC together is still ongoing – with the corporatisation of MiG and Kazan APO taking longer than planned. On March 19th, 2008, MiG’s transformation into a joint stock company was finally completed.

Plans

The government’s plan for the development of the UAC up to 2025 was presented to President Vladimir Putin for his approval February 20, 2008. The ambitious plan envisages UAC supplying 10-15% of global demand for regional and medium-stretch passenger planes, and 20-30% of global demand for military and transport aviation.
Regarding civil aviation, UAC is to focus on three vectors: modernisation and serial production of Soviet Ilyushin and Tupolev models; development of the Sukhoi Superjet and the new MS21 narrow body passenger jet. Military aviation hopes are pinned on the launch in 2015 of Sukhoi’s 5th generation fighter jet.
The program as presented will require $20bn in investment, of which $10bn will come from the budget. The share of military aviation in profits should drop to 40% from the current 80%.
On the same day the plan’s parameters were announced, Aeroflot’s general director Valery Okulov in an article in business daily Vedomosti criticised the focus on continuing modernisation of Soviet models originally developed in the 1960s. “It is not modernisation of obsolete models that will secure sustainable development of our plane building industry, but the development and launch of competitive new planes tailored to demand on the global market. Modernisation of models currently produced only targets marginal markets. But such markets do not offer steady demand and profits. This is not a plan for catching-up development, but a path to growing backwardness.”
Okulov’s words capture the basic dilemma inherent in the UAC. Is it intended to revive Soviet-era aviation producers such as Tupolev and Ilyushin or to create new, globally competitive products that represent a break with the Soviet aviation legacy? As a state-owned holding cobbled together from companies in very different financial and technological positions, containing both competitive and obsolete technologies, there is an inherent risk of political lobbies prioritising the latter at the expense of the former, and the UAC achieving the opposite of what it was intended to achieve: blocking out new development.
A fresh start: Sukhoi Superjet 100

UAC has, however, received valuable ‘start capital’ towards its strategic goal from the Sukhoi subsidiary, Sukhoi Civil Aircraft (SCA), in the form of the Superjet-100. The Superjet 100, designed and built by Sukhoi Civil Aircraft (SCA) is a regional passenger jet carrying max. 100 passengers with a range of 4,550 km and designed to compete with Brazil’s Embraer E-Jets and Canada’s Bombardier C-series.

In contrast to Soviet-style autarky, the Superjet is the result of extensive international collaboration, in which Sukhoi has played the part of system integrator. The plane flies with SaM146 engines designed and produced by Powerjet, a joint venture between Russia’s NPO Saturn and France’s Snecma. The electronics are supplied by France’s Thales, and Boeing has acted as project consultant. Besides receiving large Russian subsidies, the regional jet has been subsidised by the French (€140m) and Italian governments (€92.3m), and recently took out a 10-year $100m loan from the European Bank of Reconstruction and Development (EBRD).

Moreover, in May 2007, 25% of Sukhoi Civil Aircraft, was provisionally sold to Italy’s Alenia, a 100% subsidiary of Finmeccanica SpA, partly state-owned and also a member of the Eurofighter consortium. Alenia has also founded a joint venture with SCA to provide global after-sales and maintenance support – likely to be the plane’s main weak point. A presidential decree January 2008 sealed the deal and cleared the way for foreign nationals to become members of the SCA’s managing bodies, although only a Russian national can be head of Sukhoi Civilian Aircraft.

Sukhoi’s Superjet represents a completely new departure for Russia’s aviation industry. The plane’s main selling point is ironically – considering the Soviet gas-guzzlers the Soviet Union churned out – its operating costs being 10-15% lower than Embraer or Bombardier. Sukhoi is billing it as the most ecological in its class, so that airlines buying the plane will potentially claim Kyoto carbon credits. Moreover, a wider cabin offers more comfort – another break with Soviet tradition – and priced at $27.8m, it will be 18-22% cheaper than competitors, which could compensate for perceived lack of after-sales and maintenance network.

By mid-October 2007, SCA had 73 firm orders placed. Only ten of these were from outside Russia – placed by Italy’s Itali regional carrier, and a large number were for state-owned Aeroflot. However, at the end of October 2007, new SCA contracts were reported for 128 Superjets, worth $3.6bn in total, including orders from India’s Omega Airlines, Indonesia’s Merpati and China’s S.A.T. 350-400 Superjets must be sold for the project to break even.

The speed and smoothness of the Sukhoi regional jet’s development has surprised and impressed many observers who initially held the project for a pipe dream. Indeed, the the regional jet has proved the continued viability of Russian aircraft production and thus lent impetus to the creation of the UAC.

The EADS dilemma

UAC’S next major new commercial development is MS-21 narrow-body medium range airliner to be built by Irkut. The 130- to 170-seat MS-21 twinjet family is intended to replace the Soviet-era workhorse Tupolev Tu-154s and to compete with Airbus A320 and Boeing 737NG. The MS-21, however, is still very much on the drawing board, with main parameters still unclear and an engine still to be chosen.

Moreover, the plane is slated for serial development not before 2015. This poses a problem in as much as Aeroflot, for instance, plans to retire all Тu-154s by 2010, meaning that a gap in the market will open up inevitably to be filled by Airbus А-320 and Boeing В-737, making life very hard for the MS21 when it does eventually appear.

In fact, the issue of UAC acting as system integrator for any commercial planes larger than the Superjet is tightly bound up with UAC’s future relations with EADS. The main question is whether the EADS will deliver Russia an assembly line for the next generation A320, EADS’ mid-range liner. A320 NG would be a direct competitor of the MS-21. If EADS were to do so, UAC would be likely amend or drop the MS-21 plans.

UAC does not deny how crucial the relationship to EADS is. UAC head Fyodorov is looking to create a long-term partnership with EADS, including cross-ownership. Some degree of cross-ownership looks increasingly acceptable to EADS, despite initial alarm at the purchase of 5% of the company by Russian state-owned bank VTB in 2006. In December 2007, VTB announced it would sell the EADS stake to UAC in 2008. According to Sergei Ivanov, EADS is also ready to convert its 10% stake in Irkut for an approx. 2% stake in UAC.

EADS would then be free to increase its stake in UAC during an IPO in Russia of 10-15% of UAC stock to be held 2009-2010.

Military collaboration with India

In the sphere of military aircraft development as well, UAC is looking to develop strategic international partnerships, with India likely to play the main role as partner in developing the fifth generation fighter jet. Fifth generation fighters combine versatility with new developments such as thrust vectoring, composite materials, stealth technology, integrated avionics. Currently only the US F-22 Raptor is the only fully-fledged fifth generation aircraft operating.

In October 2007 it was reported in the Russian and Indian press that the much-hyped fifth generation fighter would be developed together with India on equal terms in a $10bn project. Indian involvement will initially be financial, but the models will subsequently be adapted by Indian engineers for Indian airforce needs. It is unclear exactly what the time frame of the project is, with estimates varying between 2010 and 2015 for production to start.

The Multi-role Transport Aircraft (MTA) is another important Indian-Russian joint that has currently hit a snag in the Indian demand that Russia reinvest in the project $10bn of Indian debt to Russia. However, both sides have considerable interest in moving on. In March 2008, it was announced that Irkut would withdraw from the project to concentrate on the MS21, leaving the MTS project wholly to Ilyushin.

In early March 2008, the Indian airforce demonstrated its trust in Russian as a strategic partner, placing a nearly $1bn order for upgrades to MiGs, despite the fact that in February Algeria had returned to Russia fifteen MiGs supplied, at a value of around $1.5bn, due to alleged inadequacies.

Backdoor protectionism: State-ownership of passenger airlines

The state has also retained considerable airline assets, including global giant Aeroflot (51.17%), and other large carriers such as GTK Rossiya (100%), Sibir (25.5%) and Krasair (50%). In 2007, it was decided to fold Krasair into a merged company called AirUnion together with four smaller regional carriers, in which the state would retain a blocking stake, and Boris Abramovich, owner of 40% of Krasair, would hold a majority stake, thus effectively privatising Krasair. The merged company would be Russia’s third largest in terms of passengers.

Obviously these extensive holdings give the state considerable leverage in supporting domestic aircraft production – simply by insisting that state-controlled carriers buy a certain quota of Russia-built planes. Of particular concern is that domestic regional carriers provide a launching pad for the Sukhoi Superjet.

In December, 2007, the state corporation Russian Technologies (RT) was established on the basis of state-owned arms export monopolist RosOboronexport, headed by Sergei Chemezov, an old friend of Vladimir Putin’s from industrial espionage activities in Dresden in the 1980s. Chemezov was predictably named head of the corporation, charged vaguely with promoting Russian hi-tech production, both defence-linked and civilian, domestically and internationally.

Russian Technologies has now laid claim to these state-owned airline assets, clearly to leverage them to promote the revival and technological upgrading of the aircraft production industry. It has not yet been finalised what assets Chemezov’s state corporation will get. Although apparently Chemezov requested that the State Property Committee transfer RT the Aeroflot stake, this is unlikely to happen. However, a Deloitte Touche revaluation of the assets of the merged AirUnion company established that the airline assets held privately by Boris Abramovich would not be sufficient to give him a controlling stake in the merged company, as was originally planned, despite Abramovich having placed orders for 20 Sukhoi Superjets.

Instead it is likely that Russian Technologies will end up with a controlling stake, thus preventing the privatisation of Krasair, and instead effectively nationalising the smaller regional airlines Abramovich merged into AirUnion. The method employed – an inflated valuation of state-owned assets relative to private assets when configuring a merger, was also used in the Irkut case described above.

If Chemezov established control over AirUnion, it is likely he will set up a holding for all the air carrier assets transferred from the State Property Agency, buying out Abramovich completely if necessary.

This latest development yet again illustrates how the policy of setting up state-controlled holdings has knock-on effects all down the line. The project of regenerating Russia’s aircraft-building industry under state supervision has prompted renationalisation of assets in metallurgy, especially titanium producer VSMPO-Avisma, as well as now seemingly in regional aviation carriers. Although the consolidation of extreme fragmentation across most sectors resulting from privatisation (there are 173 air carriers operating in Russia) should bring benefits, the fact that this is taking the form of a league of state-owned ‘national champions’ eliminates market elements, and thus stimuli to efficiency – as well as increasing the predominant power of the Kremlin vis-à-vis business and society.

However, there are increasing signs of resistance especially to Chemezov’s seemingly endless appetite for assets. With the Kremlin liberal wing encouraged by the coming Medvedev presidency, there have been sporadic attacks on ‘state capitalism’ and state corporations by policy makers, and indeed Medvedev himself. Moreover, March 18th, Sergei Ivanov himself criticised in front of the Federation Council the idea of Russian Technologies owning producers of finished products, arguing instead that the state corporation should concern itself with restructuring defence-sector suppliers of components and materials. His comments might also indicate that Chemezov had been lobbying for the United Aircraft-builders Corporation and the United Shipbuilding Corporation to be transferred to RT.

Conclusion

- The policy of uniting commercial and military aircraft producers in one holding, with a focus on production of commercial aircraft for international markets, and embedded in a system of international collaborations, is a positive sign for Western policy makers, since it will create important disincentives for Russia to sell military aircraft to internationally isolated regimes – especially as in the case of Sukhoi, when the same company seeks to sell commercial aircraft on Western markets. In the 1990s, with the aircraft sector struggling to survive, there was a policy of beggars can’t be choosers, leading Russia to export to which ever country was able to pay. The UAC’s express focus on developing and producing commercial aircraft is thus to be welcomed.

- Increasing state involvement here should not be regarded as particularly problematic. Many Western countries have or have had state involvement in aircraft production, especially for defence purposes, and the state is to a large extent merely reorganising more efficiently holdings it had retained. State direction is likely to lead directly to increased involvement of risk-sharing foreign partners and investors, and thus the long-term international embedding of the Russian aircraft production industry. This is the policy expressly being pursued. Again, this international context will dictate against the development of an autarkic ‘military-industrial complex’ that lobbies for spiralling defence spending with aggressive militaristic arguments.

- The UAC, benefiting from increases state attention and funding, will probably make more efficient use of resources to create new military aviation models retaining some degree of international competitiveness in Russian military aviation technology. However the role of international partnership (especially with India) is likely to grow here too.

- The apparent readiness of Russian authorities, when engaging in such restructuring, to exert pressure on individual owners to sell up by bringing criminal charges, even if substantiated, to bear against them, undermines the impartiality of the justice system and institution of private property.

- The policy of creating national champions has some justification especially in the aviation sector. However, it looks to be triggering a domino effect all down the line – from airlines to aircraft producers to engine producers to metal suppliers. In each segment, state-owned national champions are being formed, including straightforward cases of nationalisation such as the purchase of titanium producer VSMPO Avisma, supplier of Boeing and EADS, by Rosoboronexport. Not only does this increase the state’s share in the economy, it also squeezes out the market as coordinating mechanism, as, on the one hand, national champions, such as Aeroflot, are leant on to ‘buy Russian’, and on the other, state-owned companies are preferred as suppliers to private companies.