The primary objectives of electricity industry restructuring are enhancing the efficiency of the energy sector enterprises and creating conditions for the industry's development on the basis of private investments.

• to divide the sector into natural monopolies (electricity transmission & distribution, system operator) and competitive businesses (electricity generation, sales);
• to implement an efficient system of market relations in competitive businesses;
• to provide fair access to services rendered by natural monopolies;
• to achieve effective and fair government control of natural monopolies, which will build incentives for cost saving, and make natural monopolies attractive for investors.

Within the framework of the government policy to reform the natural monopolies, effort was continued in 2002 to restructure the electricity industry as a whole, including RAO "UES of Russia". Last year, key political decisions were taken and the first significant steps were made in that direction. During the year, the key aspects of the industry reform were discussed with the interested parties in order to work out a way to reorganize RAO "UES of Russia", determine the industry's structure and mechanisms of its work after the reform.

The major events related to industry reform in 2002 were:

• passing of the legislative package on the electricity industry reform by the State Duma;
• performance of simulation electricity trading by NP "ATS" together with OAO "UES SO-CDA";
• establishment of the sector's infrastructure organizations, the Federal Grid Company and the System Operator;
• formulation of RAO "UES of Russia" Restructuring Strategy;
• completion of the preparatory stage of RAO "UES of Russia" restructuring;
• development and approval of the basic plan for regional energos' restructuring;
• preparation for implementation of pilot projects to restructure regional energos;
• realisation of the first stages of reforming the research and development businesses of RAO "UES of Russia", and support (service) lines of business.

Legal Framework

The package of electricity reform laws that went into force in April 2003 includes the following Federal laws:

• "On Electric Power Industry";
• "On Peculiarities of Operation of Electricity Industry During the Transition Period and on Making Amendments to Some Legal Acts of the Russian Federation and Declaring Some Legal Acts of the Russian Federation Invalid in Connection with Approval of the Federal Law "On Electric Power Industry";
• "On the Introduction of Amendments and Addenda to the Federal Law "On State Regulation of Electricity and Heat Tariffs";
• "On the Introduction of Amendments and Addenda to the Federal Law "On Natural Monopolies";
• "On the Introduction of Amendments and Addenda to Part 2 of the Civil Code of the Russian Federation";
• "On the Introduction of Amendments to the Federal Law "On Energy Saving".

These laws establish:

• guarantees of reliable electricity supply to consumers and safeguarding of shareholders’ rights and interests of the State;
• procedures for the creation of a fully-fledged electricity market with free pricing;
• procedure for the formation of a new industry structure, i.e. establishment of the market infrastructure and participants;
• system for government regulation of the electricity market;
• separation of competitive businesses (generation and sales) from natural monopolies (transmission, distribution, and system operation).

Creation of Wholesale Electricity Market Infrastructure

Pursuant to the Resolution of the Russian Government of 11 July 2001, OAO "UES FGС" (Federal Grid Company engaged in the management of the Unified National (All-Russian) Power Grid) and OAO "UES SO-CDA" (System Operator engaged in operational and dispatch control of Russia's Power Grid) were established as wholly-owned subsidiaries of RAO "UES of Russia". The authorized capital of OAO "UES FGS" is RUB 127 billion. The backbone transmission lines and network equipment required for their operation (currently owned by RAO "UES of Russia") are to be transferred to OAO "UES FGS". The regional energos' trunk grids that belong, pursuant to Resolution of the Russian Government No. 881 of 21 December 2001, to the Unified National (All-Russian) Power Grid, are also to be transferred to the FGC.

The authorized capital of OAO "UES SO-CDA" is RUB 992.8 million. The Central Dispatch Administration of the UES, the Integrated Dispatch Administrations (IDAs), and the Regional Dispatch Administrations (RDUs) currently owned by regional energos, are to be assigned to OAO "UES SO-CDA". On 21 July 2002, the operational and dispatch management of the UES of Russia was transferred to OAO "UES SO-CDA".

In September 2002, Non-profit Partnership “Administrator of Trading System” (NP "ATS") launched electricity trading in simulation mode. The simulation trading is intended to make adjustments to the procedures for interaction of the market infrastructure organizations, the Administrator of Trading System and the System Operator between themselves, and their relationships with market players, i.e. electricity sellers and buyers. The rules for the wholesale market of the transitional period are being checked and adjusted, while future participants of the wholesale market are learning to work in the new market environment, getting familiar with behaviour patterns, and training their personnel. As of 31 December 2002, 130 sellers and buyers, many of which currently do not participate in the FOREM, applied to take part in the simulation trading.

Development of Plans for Restructuring of Regional Energos

In order to streamline the preparation of plans for the restructuring of subsidiaries and dependent companies of RAO "UES of Russia", ensure predictability and transparency of the reform process, a basic plan for regional energos' reorganization was developed and approved by the Company's Board of Directors on 6 March 2002, with amendments dated 3 April 2002. In furtherance of the Board decisions, RAO "UES of Russia" issued an order directing regional energos to develop restructuring plans in accordance with the basic plan.

According to the basic plan, the restructuring of regional energos is to be implemented using the principle of pro-rata distribution of shares in the newly established companies among regional energos' shareholders. In the course of restructuring of a regional energo, a power generation company (one or more), a grid company, and a distribution company are to be established on its basis. During the transition period, performance of the functions of one-man executive body (general director) of the entities formed on the basis of regional energos is to be transferred to management companies. The second stage of the reform will involve interregional consolidation of the companies established through restructuring of regional energos, which will help to create companies that are more stable and attractive to investors.

Basic Plan for Restructuring of Regional Energos

In 2002, all regional energos to be reorganized prepared their restructuring plans for consideration by the collective management bodies of OAO RAO "UES of Russia", the Russian Government's Committee for restructuring of the power industry and the Working Group attached to it. The results of the review were as follows:

• the Project Committee of RAO “UES of Russia” reviewed 45 plans;
• the Management Board of OAO RAO "UES of Russia" reviewed 42 plans;
• the Reform Committee of the Board of Directors of OAO RAO "UES of Russia" reviewed 20 plans;
• the Working Group of the Committee of the Russian Government reviewed 35 plans;
• the Board of Directors of OAO RAO "UES of Russia" reviewed 11 plans covering 14 regional energos.

A decision on the approval of each restructuring plan was taken after analyzing the target structure and mechanism for the plan's implementation, the separation balance sheet, forecast of the tariff and budget (tax) consequences, and reconciliation of the plan with the regional authorities, minority shareholders, major consumers, and creditors of the regional energos. In 2002, 32 agreements were signed with regional administrations of the Russian Federation on restructuring of the respective regions' energy systems, including Astrakhan Region, Vladimir Region, Ivanovo Region, Tver Region, Novgorod Region, Pskov Region, Nizhny Novgorod Region, Chelyabinsk Region, Omsk Region, Amurskaya Region, the republics of Karelia, Komi, Udmurtia, Buryatia, and Khabarovsk Kray.

The delay in review of the restructuring plans by the Board of Directors was primarily due to the fact that the State Duma of the Russian Federation had been postponing the consideration of the electricity reform package for a long time, which led to an uncertainty about the industry's restructuring. The restructuring plans for regional energos will be further considered in 2003.

Preparation of RAO "UES of Russia" Restructuring Strategy

The Company's management prepared the Restructuring Strategy of RAO "UES of Russia" to be reviewed by the Board of Directors. The preparation of the Strategy involved the participation of the consortium of investment advisers, OAO "Alfa-Bank" and Merrill Lynch, in close cooperation with the Company's shareholders within the Working Group established by the Board of Directors of OAO RAO "UES of Russia" for that purpose.

In the course of work on the Restructuring Strategy, regular consultations were held with the minority shareholders.

The draft Restructuring Strategy of RAO "UES of Russia" is planned to be considered by the Board of Directors in H1 2003.

Preparation for Implementation of Pilot Projects to Restructure Regional Energos.

Passing of the legislative package on the electricity industry reform by the State Duma and approving of pilot projects for restructuring of regional energos by the Electric Industry Reform Committee of the Russian Government demonstrate that the legislative and executive authorities of the country are prepared for implementation of the industry's reform. The joint plan for restructuring of four regional energos, OAO "Tulaenergo", OAO "Kalugaenergo", OAO "Orelenergo", and OAO "Bryanskenergo" was chosen as a pilot project. The project involves reorganization of all four regional energos in accordance with the basic restructuring plan followed by establishment of companies by lines of business: a generating company, a grid company, and a distribution company, comprising the respective units of the companies in these four regions.

According to the decisions taken by the Russian Government and the collective management bodies of RAO "UES of Russia", the pilot projects to restructure regional energos are to be launched in 2003.

Start of Restructuring in the Research and Development Complex of RAO "UES of Russia"

In 2002, pursuant to the resolutions of the Board of Directors and Management Board of OAO RAO "UES of Russia, 5 regional research and technology centers (RTCs) were established: Povolzhskaya Power Engineering Company, Southern Power Engineering Center, Urals Power Engineering Center, Siberian Power Research and Technology Center, and North-West Power Engineering Center. OAO "UES Engineering Center", an institution established in 2001, also operated successfully. Five Research and Development Institutes were transferred to OAO "UES FGC" for management. Work has been started to prepare several large and self-dependent Research and Development Organisations (ENIN, VTI, NIIES, VNIIG) for restructuring on the basis of individual plans.

The principal advantages of RTCs are: a comprehensive and versatile approach, the ability to deliver large projects on a turnkey basis, high efficiency of work.

Corporate management at each RTC is carried out under contracts by a management company, which, as a rule, is established on the basis of a transformed research and development organization. Such corporate management system is a transitional stage before consolidation of the R&D organizations. 2003-2004 will see efforts to merge AO-research institutes with the RTCs (management companies) in order to establish competitive companies delivering comprehensive engineering services and maintaining market leadership in Russia and abroad.

In the context of restructuring of RAO "UES of Russia" accompanied by the establishment of independent companies and the creation of a competitive market for electricity, and the amendments made to the Tax Code of the Russian Federation, it became necessary to increase cost efficiency of research and development work at regional energos and AO-power plants, which requires to reform respectively the mechanisms supporting this work. For that purpose, in accordance with the resolutions of the Board of Directors and Management Board of OAO RAO "UES of Russia", work to establish a finance and information intermediary (R&D Broker) - Non-profit Partnership "Innovations in Electricity Industry" (NP INVEL) - has been underway since November 2002. The Partnership members are OAO RAO "UES of Russia", OAO "UES CDA", OAO "UES FGC", and regional energos, AO-power plants, management companies, power engineering companies, and other market players. The legal procedures to establish NP INVEL are expected to be completed in 2003, followed by work to organize its business activities.

Decision to Restructure the Repair and Maintenance Line of Business

The decision of the Board of Directors of OAO RAO "UES of Russia" of 27 September 2002 states that the maintenance businesses are to be restructured at a pace faster than the reorganization of regional energos.

The following goals were set for the restructuring of the maintanance line of business:

• enhancing efficiency of the energy companies' principal lines of business through more efficient utilization of funds allocated for maintanance and technical re-equipment;
• development of a competitive market environment in the maintenance and re-equipment business;
• Observance of interests of shareholders in RAO "UES of Russia" and regional energos in the course of restructuring of the maintenance line of business.

At the first stage of reorganization of maintenance businesses (Q1-3 2003), the power maintenance entities will be divested through establishment of wholly-owned subsidiaries of regional energos or AO-power plants or through spin-off in the course of regional energos' restructuring. At the second stage, the degree of affiliation of the newly established maintenance companies to the energy companies will be reduced through sale of regional energos’ and AO-power plants’ stakes in the maintenance companies and interregional integration of the newly established maintenance subsidiaries.