RS Market breakdown Domestic and communal services in Russia. Growth in the sector is being hindered by corruption and depreciation in the major funds

Domestic and communal services in Russia. Growth in the sector is being hindered by corruption and depreciation in the major funds

September 2013

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Domestic and communal services is an area that has shown stability in terms of demand for services, and whilst this is important to investors, it does not amount to a guarantee that they will make a return on their investment. In order for good returns on investment to be made in the sector, cost savings must be made in the use of infrastructure. This means that equipment and networks must be modernized, within the fixed maximum rate. In Russia there is yet another problem, in addition to those mentioned above: high levels of corruption, which the authorities have as yet been unable to overcome. On the one hand, investors certainly have their place in the sector, but, on the other hand, the right conditions for investment have yet to be put in place.

A series of significant amendments have been made over the last two years to the plan of action, approved by the RF government in 2011, to attract private investment in the domestic and communal utilities market, but doubts remain as to whether the end result will actually be achieved.

This is the view of Mikhail Mamaev, the General Director of the Financial Scientific and Innovation Institute for Economic and Legal Studies, at the Financial University under the RF government, and the long-term rates proposed in the plan in order to ensure stability are fixed, and inflation won't be going anywhere. Maintenance costs for infrastructure, in addition to modernization costs, are on the rise, in addition to prices for the relevant materials and services. Moreover, the low level of collection rates for payments for domestic and communal services, particularly in the regions.

"Investors will be fully dependent on civil servants, primarily when economically justifiable costs are determined, and for that reason illegal, corrupt payments will become an integral part of expenses. As a result, competition in the sector is unfair, and is characterized by the lack of a level playing field for companies attempting to break into the market for these services, and this is leading to a spike in prices," Mr Mamaev suggests. "Moreover, civil servants from local authorities will be able to transfer liability for accidents and other unforeseen situations to the private sector."

Given that it takes at least 10-15 years to secure a return on investment in the domestic and communal services market, and that the government's plan of action stipulates a period of at least 3 years for fixing rates, decisions on whether or not to invest will be strongly affected by the lack of clarity about the rules of the game further down the line, as set by the state. Experience over the last few years, particularly in the field of electricity, points to the fact that these rules are not going to change in favour of investors. Long-term financing of investment projects in the domestic and communal services sector is possible in Russia only if the state gets involved, taking account of the fact that depreciation in the main funds is over 60% according to experts.

Encouraging private companies to enter this market now using administrative funds, usually described as "quasi-market" relations, would not be viable in the long run. Private ownership can be effective, but not when the private company's income is subject to state regulation by means of rates - not in the conditions that apply in Russia, at least. The privatization of the electricity network, and specifically the energy sales complex, showed this to be the case. Given the lack of clarity regarding the future rate, which depends first and foremost on political conjecture (and on whether promises made during the election campaign are kept), the private sector will seek a guarantee that the funds at its disposal can be safeguarded, inter alia by putting them towards modernization rather than investing them.

Management of domestic and communal services facilities must therefore be in private hands, whilst the facilities themselves should be held by municipal authorities.

According to Mikhail Mamaev, it would make sense to allow unallocated state funds to be put towards modernization of equipment and communications in the field of domestic and communal services. The most suitable resource would be the RF Pension Fund, with the relevant legislative base created, including by means of specially created funds, and subsidies in the form of reduced interest rates for long-term bank loans in the field of domestic and communal services.

The entire sector seems to suffer from a total lack of transparency, and, to an even greater extent, corruption

Cheap and long-term loans can also be provided by means of attracting cheap, long-term loans by issuing special long-term bonds, guaranteed by municipal authorities. Banks that are partially state-owned could act as the customers for such bonds, which would mean they were effectively investing in the field of domestic and communal services.

Daria Pichugina, an analyst at the Investkafe agency, also notes that the sector's main problem is the depreciation of its primary funds. "Many buildings in Russia are in need of major repairs, while piping and sewage systems are also in a sorry state," she maintains. "The whole system is ineffecient, there aren't enough people employed in it, and moreover the sector is seen as one of the most corrupt in Russia."

Narek Avakyan, an analyst from the financial company "AForex" also highlights the problem of corruption.

"I consider this sector to be one of the most inefficient in the entire Russian economy. With the exception of electric energy, the whole sector seems to suffer from a total lack of transparency, and, to an even greater extent, corruption, to be frank," the expert warns. "In many ways it is a closed system, and it is not very welcoming to investors: only about 25% of companies in the sector are public companies, or at least make their reports public. At the moment I can't personally see any particular trends or tendencies in this sector, because there is simply no growth at all. There are a number of reasons for this. Firstly, there's no competition: paradoxical as it may seem, it would be fatal for this sector to have a large accumulation of unsupervised companies, because it is an industry based on infrastructure, and you can't just open up an electric power station somewhere as you would a supermarket - it's a much more complex and costly process. Secondly, for this reason local monopolies are effectively being formed, which are only partially regulated. That's precisely why the so-called rate system for pricing of companies' services in this sector is in place. And this system is also extremely inefficient, because not only are rates for domestic and communal services growing at more than twice the rate of inflation, but there are fewer and fewer incentives for the providers of these services themselves to break into sales markets, and increase output and efficiency, because they already face a guaranteed annual increase of 15% on rates. Given that communal services are socially significant, there is no price elasticity of demand (i.e. demand has no direct correlation with pricing)."

In other words, Mr Avakyan adds, the cash flows of communal services companies are increasing by 15% year on year, without any efforts being made to improve efficiency from their side. "In future, I think this sector is going to be reformed, and it may be that a single communications company will be set up, in the form of a natural monopoly. And that would be the best solution, because it would make it much easier to regulate the rate policy, whilst simultaneously targeting inflation", he adds.

There are some serious problems with rates, too - the manner in which they are determined is far from transparent.

Sergey Kulikov,
Economic Commentator for Nezavisimaya Gazeta
Еxclusively for Russian Survey RS