Overview (July 2000)

Electricity Sector
Oil and Gas

Electricity Sector

Background
Although Georgia has some domestic sources of energy, it has always been highly dependent on imports to meet its energy demands. Dependence on external sources was never a problem for the country during the Soviet era, when Georgia was fully integrated into the unified Moscow-managed energy system of the Soviet Union. The breakup of the Soviet Union, however, hit the country's power sector heavily. In the early 1990s imports from neighbouring countries ceased and the country faced an acute energy crisis. In addition, the country went through a period of civil disturbances, which led to disruption of the energy and fuel supply networks. Since the crisis began, constant disruptions and shortages of electricity have adversely affected almost the entire population of Georgia, and certain parts of Georgia do not receive any electricity at all. Currently, the weakness of Georgia's power sector is one of the biggest obstacles to the country's economic growth.

All of Georgia's existing hydro and thermal generation facilities are in poor condition, and are in dire need of upgrade and rehabilitation. Although the total installed capacity in Georgia amounts to approximately 5,090 megawatt hours (MWh) (consisting of 2,843 MWh of hydroelectric sources and 2,088 MWh of thermal power sources), the generation sources are currently producing at only 20% of installed capacity. The power sector still suffers from inefficient operation, inadequate planning, poor billing practices, low collection rates and a rapidly deteriorating physical plant. The cost of upgrading these facilities to international standards is estimated at over $1.3 billion.

In order to improve the situation in the power sector, and under pressure from international financial donors, Georgia's government has undertaken an aggressive restructuring and privatization programme. The reform of Georgia's power industry began with the separation of the vertically integrated state power utility company Sakenergo into generation, transmission and distribution enterprises, as a step towards privatization of state property. The progress in institutional, legal and regulatory reforms, including the adoption of the Law on Natural Gas and Electricity in 1997 and the establishment of the Georgian National Energy Regulatory Commission (the NERC), has created a comprehensive framework for further restructuring and privatization of the industry.

The existing national transmission grid consists of nearly 10,000 kilometres (km) of 500-kilovolt (kV) , 330-kV and 220-kV transmission lines, and 21 major substations. The 500-kV line is the transmission backbone, connecting the western part of the country where most of the hydro generation is concentrated (including Inguri, the largest power plant in the country) with the eastern part where the largest thermal plants are situated. The 500-kV line is also the main regional transmission line connecting Georgia, Russia and Azerbaijan. Georgia has another 220-kV link with Armenia, a 110-kV link with Turkey, and 220-kV and 330-kV connections with Azerbaijan. Only one section of the grid (600 km of 500-kV lines) is privately owned, while the rest of the transmission grid assets belong to the state-owned company Elektrogadatsema.

One of the problems in the Georgian power sector is the significant transmission and distribution losses due to deterioration of equipment. It is estimated that at least 25% of all energy produced is lost due to technical factors. Most of the transmission system is in an unacceptable condition, and some of the lines and substations need immediate rehabilitation.

The main national dispatch centre is located in Tbilisi, with regional dispatch centres located in Kutaisi (the second-largest city in Georgia) serving as its backup. The dispatch functions are currently handled by Elektrodispatcherizatsia Ltd, a state-owned company. Although the dispatch centre uses outdated equipment and requires substantial rehabilitation and installation of modern technology in order to meet world standards, the government does not intend to privatize it in the near future.

Regulatory framework
The current Law on Natural Gas and Electricity, which came into force in 1997, outlines the legal framework for establishing the NERC and regulates the generation, transmission, distribution and consumption of electricity in Georgia. The NERC, in turn, has developed a number of regulations and rate methodologies that provide a relatively stable and transparent regulatory climate.

Regulatory agencies
Agencies that regulate the industry include:

• the Ministry of Fuel and Energy;
  
  
• the NERC; and
  
  
• the Wholesale Energy Market.

The Ministry of Fuel and Energy
The Ministry of Fuel and Energy of Georgia establishes the basic guidelines for the development of the country's power industry. It elaborates short and long-term strategies and sets priorities, establishes uniform state energy programmes and develops the rules for restructuring and privatization of the industry. The ministry issues permits for setting up new generation facilities.

The NERC
The NERC was established as an independent state agency empowered to regulate the energy industry in Georgia. As such, the NERC creates standards and policies necessary for the operation and development of the country's energy sector, oversees the industry's performance, issues licences necessary to carry out business in the energy sector and regulates tariffs.

The NERC consists of three members, each appointed by the president of the country for a six-year term. The NERC is not subordinated to the government. However, it must follow the basic guidelines elaborated by the ministry and approved by Parliament.

The NERC has the authority, within its area of competence, to hear disputes between power sector companies. These companies must first apply to the NERC, and only if the dispute is not resolved by the NERC may they bring the dispute to a court. All licensees in the energy sector (ie, generation, transmission, dispatch, distribution, energy import and export companies) must pay the NERC a regulatory fee sufficient to cover all budget expenses of the regulator.

Wholesale Energy Market
The Georgian electricity market is based on a model under which independent generators of energy sell their output to a purchasing agency, the Wholesale Energy Market of Georgia (WEM). The WEM purchases both low-cost hydropower and high-cost thermal energy at market prices, and sells energy to distribution companies at the average of the high and low costs. Unless approval is obtained from the NERC, all electricity produced by generators in Georgia and imported into the country must be sold to the WEM. As the sole authorized power wholesaler in Georgia, all power purchases go through the WEM (again, subject to limited exemptions allowed for direct power purchases).

The primary functions of the WEM are to manage the Georgian electricity market and to be a broker in all financial transactions between sellers and purchasers of electricity. The WEM itself owns neither electricity-generating assets nor transmission or distribution lines. All dispatch and transmission services are provided to the WEM by dispatch and transmission companies respectively.

The WEM was created in the form of an association of legal entities, all of which retain their separate legal identity. Membership in the WEM is mandatory for all energy sector licensees in Georgia (ie, generation, transmission, dispatch, distribution, export and import licensees) and only members of the WEM are allowed to be connected to the transmission grid. Direct consumers who are directly connected to the transmission grid must also become WEM members. All members must pay membership dues in an amount determined by the WEM.

The WEM is governed by the general meeting of WEM members and by the executive board, which is composed of representatives of dispatch, transmission, distribution and generation companies, as well as representatives of direct consumers and certain government agencies (it has 12 members in total). The members of the board are appointed by the NERC upon nomination by the represented entity. The board elects its chairman, who must be approved by the NERC. The day-to-day operations of the WEM are run by its general director, who is nominated by the executive board and appointed by the NERC.

The WEM operates on the basis of the Market Rules adopted by the WEM and approved by the NERC. Failure of a WEM member to comply with the Market Rules may result in suspension or termination of its membership in the WEM, and, accordingly, the inability to operate on the energy market.

Tariffs
Tariffs for electricity are controlled by the NERC. The NERC has indicated that companies operating in the power sector should be able to price their services high enough to enable them to receive a return on their capital investments, taking into account reasonable rates of return and applicable taxes.

In accordance with the move towards a market economy, energy prices are supposed to be uniform for all purchasers with the same characteristics, and differentiated prices are supposed to reflect the different costs of delivering energy to industrial, commercial and residential users. Currently, differentiated tariffs are uncommon, but a move towards differentiated tariffs is likely to occur in the short to medium term.

Licences
The NERC is responsible for the licensing of power sector activities. Under Georgian legislation, any company that wishes to generate, transmit, distribute, dispatch, import or export electricity needs a licence from the NERC. Given the draconian nature of the penalties imposed for operating a power facility without the required licences, and the critical importance of an appropriate (ie, economically feasible from the investor's perspective) tariff structure being adopted and applied, it is difficult to overemphasize the importance of dealing effectively with licensing and tariff issues at all stages of an investment in power generation, distribution or transmission facilities in Georgia.

Oil and Gas

Georgia's importance in world oil markets stems mostly not from its own hydrocarbon resources, but from its location as a growing oil and natural gas transit centre for Caspian Sea oil from Kazakhstan and Azerbaijan. Estimated proven oil reserves in the country amount to 12 million tonnes, and probable reserves are estimated at 580 million tonnes. Current oil production amounts to about 130 thousand tonnes annually. Despite its limited resources, Georgia is taking steps to increase domestic production. In September 1999, Georgia reduced the profit tax for foreign developers in the oil and gas sector from 10% to 4%.

The Georgian Law on Oil and Gas was passed in April 1999 and contains a variety of provisions specifically aimed at regulating oil and gas activities. The law has provided some legal clarity necessary to attract foreign investments (although some issues still remain to be clarified) . It has also established a fully empowered single authority - the State Agency for Regulation of Oil and Gas Operations - to negotiate contracts and sign agreements, issue licences and regulate the industry. A few of the more pertinent provisions for oil and gas operations are discussed in the next section.

State Agency for Regulation of Oil
The Law on Oil and Gas empowers the State Agency for Regulation of Oil to act on behalf of Georgia in concluding any exploration and production agreement with any developer of oil reserves in Georgia. The agency is responsible for issuing licences necessary for performance of oil and gas operations, and for securing the issuance of all other licences, permits and authorizations to the developer.

Saknavtobi
The National Oil Company Saknavtobi, (a company 100% owned by the state) is one of the key players in the oil and gas industry. Under the Law on Oil and Gas, Saknavtobi is empowered to act on behalf of the state in relationships with any private oil developer, including such functions as the following:

• participation in negotiations between a developer and the agency;
  
  
• acting on behalf of the state in the course of implementation of all oil and gas exploration and development agreements; and
  
  
• disposition of the state share of oil and gas produced in Georgia.

Tender
Under the Law on Oil and Gas, a potential developer cannot be granted the right of exploration and production of oil on any particular field without a properly conducted tender or auction. The agency is responsible for choosing fields to be given to a developer, and for carrying out tenders and auctions.

The winner of a tender or auction must enter into an agreement with the agency in order to be entitled to perform any oil and gas operations. The Law on Oil and Gas enumerates three types of oil and gas exploration and development agreements:

• production sharing agreements;
  
  
• risk service agreements; and
  
  
• service agreements.

Once the agreement with the agency is concluded, the agency issues an oil exploration licence to the developer.

Dispute resolution
The Law on Oil and Gas specifically establishes the exclusive jurisdiction of Georgian courts with respect to disputes that relate to land or real property. Disputes not directly related to land and real property may be brought before international arbitration, provided that the oil developer is not a resident of, or a legal entity registered in, Georgia.

Oil transportation
Due to its strategic geographical position between Europe and Central Asia, Georgia remains the gateway for land transportation across the Caucasus, and its location on the Black Sea is the one of the country's main assets. Georgia is a part of the Eurasian Transport Corridor, envisaged as the primary transport route for transportation of oil and gas from the Caspian region to Europe.

Georgia has concluded a 30-year agreement with the Azerbaijan International Oil Company (AIOC) (an international consortium created to develop oil and gas fields in the Azerbaijani sector of the Caspian Sea) to build a pipeline to transport oil from Azerbaijan. The pipeline from Baku, Azerbaijan to the Supsa oil terminal in Georgia was commissioned in April 1999, and currently transports around 115,000 barrels per day. The Georgian International Oil Company, created specifically as a counterpart to AIOC, made substantial upgrades to the existing pipeline and built the Supsa terminal at a cost of $565 million.

The importance of Georgia as a transit route will increase sharply with the construction of the proposed 1 million barrels per day Main Export Pipeline for oil exports from the Caspian Sea. The World Bank has provided financing for a feasibility study, including options for a pipeline to Ceyhan, Turkey. In November 1999, the United States, Georgia, Azerbaijan, Turkey and Turkmenistan signed the Istanbul Declaration, supporting a Baku-Ceyhan route passing through Georgia.

Georgia is already a rail transit centre for Caspian Sea oil, and 60,000-80,000 barrels per day of oil from the Tengizchevroil project in Kazakhstan are shipped by barge across the Caspian Sea, then carried by rail across Azerbaijan to Batumi, one of the Georgian Black Sea ports.


For further information on this topic please contact Mark Lockwood or Alex Korchagin at Baker & McKenzie's Almaty office by telephone (+7 3272 50 99 45) or by fax (+7 3272 50 95 79) or by e-mail ([email protected] or [email protected]).