Russia Is A Large, Global Nuclear Player

Since commissioning its first 5 megawatt (MW) nuclear power plant (NPP) in Obninsk in 1954, Russia has been one of the world's leading countries in nuclear power generation. Russia plays an important role in all parts of the nuclear cycle, from mining to construction.

We rate Atomic Energy Power Corp. JSC (BBB-/Stable/A-3), Russia's monopoly 100% state-owned nuclear player, at the level of the sovereign foreign currency rating (BBB-). AEPC is a vertically integrated company which covers all stages of the civil nuclear cycle from uranium extraction (about 13% of global production) through enrichment and fuel fabrication (about 36% and 17% global market shares) to electricity generation in Russia. It is the sole operator of nuclear plants with 29.1 gigawatt (GW) total installed capacity, corresponding to about 12% of Russia's total installed capacity and 19% of the country's electricity production, at 10 stations and 35 units in operation (see chart 1).

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Nuclear has a solid 19% share in Russia's generation mix (2018). The government plans to maintain approximately the same share, in line with its energy strategy, by gradually replacing old RBMK-type reactors with new VVER (pressurized water reactor) ones and by proportionately increasing all types of generation to meet incremental rises in demand.

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While many developed countries in Europe (notably France, Germany, and Spain) focus on gradually phasing out their nuclear generation fleet, Russia, together with China, is among the global leaders in commissioning new NPPs domestically and abroad. Of nine reactors connected to the grid in 2018 globally, three were Russian-designed (Leningrad 2-1 and Rostov-4 in Russia, and Tianwan-4 in China), and the rest were in China. In 2019, one out of the two reactors connected to the grid was Russia's Novovoronezh-2-2. Of 6 NPP constructions started globally in 2018-2019, four are being built by Russian companies (Akkuyu in Turkey, Rooppur in Bangladesh, and two units in Kursk).

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Low Construction Costs Are The Key To Competitiveness

In contrast to some international peers, AEPC's nuclear generation is very cost competitive. There are three main reasons: relatively low construction costs, low additional nuclear-related costs (for example, no additional nuclear-related taxes), and high capacity utilization.

Generally, nuclear generation has low marginal costs but very high capital costs (roughly 60% of the levelized cost of energy). NPP construction costs are increasing globally because of tightening regulations, delays, and complications that increase capital expenditure and imply an additional cost of capital tied up in construction.

The main advantage comes from the fact that NPP construction in Russia is considerably cheaper than in Europe. We estimate construction costs, excluding financing costs, at about USD2 thousand per kilowatt (kW) of capacity at some recently completed units in Russia, compared with about USD4 thousand per kW budgeted for AEPC's Akkuyu project in Turkey (for a total cost of USD20 billion; four units at 1.2GW each), and about $5.5 thousand per kW for Paks in Hungary. This compares to estimates of about USD5.5 thousand per kW for Europe, USD3.5 thousand per kW for China, and about USD5 thousand per kW for the U.S., according to the estimates published by the International Energy Agency and the World Nuclear Association.

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The main factors supporting low construction costs are:

• Rapid ruble depreciation in 2014. The Russian ruble (RUB) declined RUB69.71 at year-end 2018 from RUB32.73 at year-end 2013 and RUB56.26 at year-end 2014. Given AEPC's vertically integrated structure, essentially all local NPP capex is in RUB, and the ruble-denominated cost of construction has not changed much since then.
• Learning curve and serial effects. While most European peers essentially stopped large-scale NPP construction after 1986 Chernobyl tragedy, AEPC and its sister companies have been commissioning new NPPs in Russia (2016: Novovoronezh-2-1; 2018: Rostov-4, Leningrad-2-1, 2019: Novovoronezh-2-2) and abroad (2018: Tianwan-4, 2017: Tianwan-3, 2016: Kudankulam-2). AEPC uses standardized designs, has teams with recent experience of successful NPP builds, and builds most new units either to replace existing ones, or in close proximity to the ones under operation, which allows for operating and construction synergies.
• Vertical integration. This reduces coordination risks for complex projects like NPP construction.

Supportive Russian government policy as well as country-level regulations and enforcement are essential to ensure low construction cost and support operating profitability.

Russian Government Policy And Electricity Market Design Support High Profitability

In contrast with many countries, which have been tightening nuclear regulations and preparing gradual nuclear phase-out plans, the Russian government views the nuclear sector as a reliable source of energy as well as a support to economic growth via exports of engineering services, equipment, and fuel.

In Russia, where environmental policies are not at the top of political or social agenda, renewable penetration remains low and social acceptance of nuclear power remains very high, according to polls. Also, the nuclear industry has a national security dimension and plays an active role in the country's most strategic projects, including nuclear icebreakers for the Northern Sea Route (used to supply remote territories and export commodities such as platinum, palladium, nickel, or liquefied natural gas) and potentially treatment of nonnuclear hazardous Class 1 and 2 industrial waste. The fact that AEPC's subsidiaries and sister companies are the leading employers in certain "company cities," with a highly specialized and skilled workforce, is yet another reason for the government's supportive stance.

We view the Russian government's policy as supportive to domestic nuclear generation for the following reasons:

• Supportive regulations for nuclear power construction,
• Capacity supply agreements,
• Low nuclear liabilities,
• Local electricity market structure and design, and
• Ad hoc government equity injections for nuclear power construction.

Although all NPPs globally should comply with the International Atomic Energy Agency's, environmental regulations at the country level differ substantially, both in terms of actual engineering requirements and the set of documents to be presented to the regulator. The local regulators' experience and clarity of regulatory requirements are essential for obtaining necessary permissions for NPP construction and to avoid costly and difficult changes to assets already partially constructed. The Russian regulators, similarly to AEPC employees, have accumulated significant experience with recent NPP commissioning and with AEPC's standard engineering solutions.

Capacity supply agreements for the nuclear sector support payback of capex in 25 years and a basic return on investment at a solid 10.5% (although down from 14% in 2011). Although the Russian government uses such agreements to support investments in all types of electricity generation, not just nuclear, and although 10.5% should be read in the context of high domestic interest rates, the cost of nuclear construction is also higher, which means that the resulting price of nuclear capacity is well above thermal. Capacity payments therefore provide a solid boost to AEPC's EBITDA. Nuclear capacity payments totaled RUB116 billion in 2017 (over one-third of AEPC's consolidated EBITDA) and are projected to be about RUB221 billion by 2021, if the company sticks to its current construction plans.

In line with Russian law on nuclear waste, AEPC is only responsible for nuclear liabilities accumulated after the law came into force in 2011. Even if technically, AEPC is the only entity in Russia that can store and process nuclear waste, financial liability remains with the government. As a result, according to AEPC's IFRS report, the company's total year-end 2018 pretax asset retirement liabilities were RUB145 billion (USD2.1 billion), including RUB58.8 billion for fixed-asset retirement, RUB10.5 billion for land (including liabilities related to mining operations), RUB64.2 billion plus RUB5.9 billion for nuclear fuel waste, and RUB5.8 billion other.

Supportive electricity market design makes local nuclear generation profitable and cost-competitive compared to other fuel types. The cost of nuclear power generation in Russia benefits from high capacity utilization (78% in 2018, according to the Ministry of Energy), because AEPC has priority access to the market and can sell all its electricity at prevailing market prices, which mainly depends on thermal generation costs. Although the average age of AEPC's reactors is comparable to European peers (with median about 30 years), there are not as many interruptions caused by maintenance. Large nuclear power plants in Russia usually have a lower share of less profitable heat and electricity sales at regulated prices compared to smaller thermal generation. Electricity prices in Russia are considerably less volatile than those in many European countries, given low penetration of intermittent renewables and the fact that domestic gas prices--the main cost component for thermal generators--are regulated and therefore stable, that is, increasing only gradually with inflation. Also, AEPC doesn't face any specific nuclear-related taxes--unlike in some European countries such as Sweden.

In addition, AEPC has a track record of ad hoc targeted financing for various capex projects, for example, the construction of the floating NPP Lomonosov in 2018). At RUB13.6 billion in 2018 (RUB22.7 billion in 2017), equity infusions are not essential for the company's financial metrics, but still positive. Also, we understand that the government plans equity contributions for AEPC's and Rosatom's new strategic initiatives outside of their core business but linked to national priorities (such as nuclear icebreakers for the Northern Sea Route, nuclear medicine, treatment of hazardous nonnuclear industrial waste). This enables AEPC to raise its visibility, standing vis-à-vis the government, and its social profile while avoiding an increase in debt. AEPC's direct parent, Rosatom, has the special legal status of a State Corporation, which was set up by the Russian government as a public entity to achieve broad energy policy goals.

These benefits support profitability and APEC's business risk profile. Still, they should be considered in the context of the high risks of doing business in Russia, where regulations are often changing and subject to one-off political interference. For example, in case of hypothetical large nuclear accidents, we understand that the Russian government can provide support, but the law does not provide any clear mechanism for this (in contrast to some other countries with large nuclear generation, such as France).

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Large International Projects Are The Key Risk

AEPC's parent Rosatom, via AtomStroyExport, has a large portfolio to construct 36 new nuclear power units in several countries. Of this, AEPC itself is undertaking two complex and capital-intensive projects that will likely turn its free operating cash flow (FOCF) negative. First, AEPC is a 96.91% shareholder in the Akkuyu NPP in Turkey. Construction started in April 2018 and will reportedly cost approximately US$20 billion for four 1.2GW units, of which the first one begins operations by late 2023. Also, AEPC is a 34% shareholder (via RAOS Voima) and provider of engineering and technical services for the Hanhikivi NPP in Finland (about €6.7 billion), where completion was initially scheduled in 2023, but according to press reports will likely be delayed until 2028 because the necessary regulatory approvals have not yet been received. We understand that the delay will not expose AEPC to any financial penalties, but rather the company will postpone large capex, which were prefunded with a RUB57.5 billion equity contribution from the Russian government in 2015 and that we have treated as restricted cash. Also, we believe that because the project is delayed and not cancelled, AEPC will not be required to return this equity contribution to the government.

Generally, we view NPP construction as the highest-risk part of the nuclear industry. Many industry peers (such as Westinghouse and Areva) have recently faced severe setbacks due to significant cost overruns or delays in construction. Despite a positive track record of carrying out construction projects and although the international projects use the same design as the new units that AEPC recently successfully commissioned in Russia (Leningrad and Novovoronezh), we cannot rule out delays or regulatory or operational issues that may increase the projects' costs, defer the benefits, or bring reputational risks to AEPC. Although the primary contractor for most projects, AtomStroyExport, is a sister company outside of AEPC's scope of consolidation, the company provides engineering and construction services and supplies fuel to the new plants. Under our base case, we don't assume that AEPC will consolidate AtomStroyExport. Still, we believe AEPC may feel indirect effects if its sister company faces any unforeseen operational, regulatory, or financial difficulties related to any of its large projects.

The key mitigant for construction risks is that AEPC and Rosatom mostly focus on "nuclear-supportive" countries where primary energy demand is increasing and environmental constraints on the nuclear sector are less pronounced, such as China or India. However, Finland has very strict domestic environmental regulations on top of general International Atomic Energy Agency requirements and was the country where Areva's Olkiluoto NPP faced numerous delays and cost overruns.

The Russian government's policy is aimed at boosting currently sluggish economic growth in the country via investments and exports. The government therefore provides ongoing political support in negotiations with international partners on NPP construction or fuel exports. In addition, the government, directly or via government-related financial institutions, provides loans to host countries for s NPP projects, like an export credit agency. For example, Belarus received a USD10 billion loan from Russia for the new NPP construction (at an expected cost of $11 billion for two 1.2GW units together). Hungary plans to receive a €10 billion loan from Russia to back construction of a €12.5 billion Paks-2 plant (two 1.2GW plants), which sparked controversy in the EU. Kudankulam 5 and 6 in India is getting a $4.2 billion 10-year intergovernmental loan from Russia. The largest part of the USD13 billion in construction costs for Rooppur NPP in Bangladesh (two 1.2GW plants) will be covered by a loan from Russia. According to the press, the intergovernmental loan for the new NPP in Uzbekistan is under negotiation. Even though these are interest-bearing loans and not state subsidies, they ensure the availability of capital for long-term and complex NPP projects and remove the financial burden of costly construction from AEPC.

A different model is used for AEPC-level build-operate-own contracts in Turkey and Finland, where AEPC is the shareholder and therefore bears large construction costs, implying much higher risk for credit quality. Only a small part is covered by an equity contribution from the Russian government to AEPC. The government's Welfare Fund has agreed to provide up to RUB150 billion for Hanhikivi, of which RUB57.5 billion was paid in 2015; for Akkuyu, up to a USD2.7 billion equity contribution is expected, including an in-kind portion. We understand that AEPC, with the Russian government's political backing, is looking for a local partner for up to a 49% stake in Akkuyu which, if successful, could help to share the massive construction costs, while a fixed electricity offtake contract with the Turkish company Tetas at a very attractive price (12.35 cents/KWh) should support the project's economics.

Although the massive cost of construction will turn AEPC's FOCF negative and significantly increase debt, the key offsetting factor is AEPC's currently solid financials, with large cash reserves (at year-end 2018 it held RUB370 billion in cash, RUB17 billion in deposits, and RUB106 billion in financial investments), low debt (debt to EBITDA is less than 1x) and cash-generative core operations in Russia (with 2018 reported FOCF of RUB140 billion). This represents a solid financial cushion for large future investments.

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Sanctions Add Uncertainty For The Global Nuclear Industry

Given AEPC's strong links with the Russian government, we believe the company's international activities could be exposed to risks related to Russia's political relationships with other countries. This may affect competition for international NPP construction, in our view. Similarly to other large Russian players, AEPC faces risks related to general perception of Russian companies by international investors.

The U.S. Congress is currently considering sanctions on international projects of Russian parastatal entities and uranium exports to the U.S. Many large Russian banks and corporate entities face sanctions ranging from limitations on issuing long-term debt to individuals and companies on the U.S. government's Specially Designated Nationals And Blocked Persons List (SDN), which prohibits U.S. persons from doing business with them. AEPC is not subject to any sanctions, and sanctions are not part of our base case scenario. Also, AEPC has solid liquidity and mostly relies on funding from large Russian banks and the government rather than the international capital markets.

Still, if the U.S. were to apply sanctions against international nuclear projects involving Russian government-related entities or against uranium and nuclear fuel exports, we believe the impact on the global nuclear industry would be unpredictable, because Russia is a big player on the international market for nuclear fuel and enrichment services. The recent case of Rusal, a large Russian aluminum company with a significant international presence, which was placed on the SDN list in April 2018 but removed in January 2019 in response to its plan for a change in ownership, illustrates that sanctions can have widespread side effects on markets.

A Slowly Growing Domestic Market--And Risks Abroad

We expect Russia's domestic nuclear capacity to increase only moderately, over the next few years at least, due to demand constraints. Electricity demand in Russia is stagnating, given only modest GDP growth, a significant potential for energy savings, and the government's intention to avoid pressure for higher end-user electricity prices from increases in capacity payments.

Nuclear capacity payments were among the primary reasons for the increase in end-user electricity bills in 2016-2018 (see chart 7), and are expected to grow further as new units are commissioned. We expect AEPC to continue replacing its aging reactors with new ones and to continue to benefit from existing capacity supply agreements already in place. However, new or early-stage projects aimed at capacity expansion are less certain, in our view.

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We expect broadly stable revenues from exports of fuel and enrichment services. In AEPC's main export markets, nuclear remains a favored option, while phase-outs at less nuclear-friendly countries are only gradual, which should support export volumes. AEPC should also benefit from new long-term contracts to supply fuel to recently built NPPs (for example, Tianwan in China). We understand that switching to a new nuclear fuel supplier may not be technically straightforward for customers. Now that Fukushima is back in operation, international prices have stabilized and started to recover slightly. Still, we believe prices will remain relatively weak for the foreseeable future because of limited new additions to global nuclear capacity and several countries' decisions to gradually phase out nuclear generation (notably Germany, France, and Spain).

In our view, the key risk will come from international NPP construction, notably in countries with strict environmental regulations, which could trigger significant delays and reputational risks. This would especially be the case if construction starts before all approvals are received, and meeting new regulatory requirements would require reconstruction and large amounts of additional capex.

We expect decommissioning services and nuclear waste treatment to increase in importance in the global nuclear industry, which could benefit AEPC's EBITDA, as the company is an important global provider of such services. AEPC is currently developing a new technology aimed at recycling used nuclear fuel at fast-neutron reactors to eventually achieve a fully closed nuclear cycle. If successful, this could help address the fundamental challenge of the nuclear industry--treatment of nuclear waste. We understand that this technology is currently at research and development stage.