Company Profile. History of the Reform

RAO "UES of Russia" was established in 1992 pursuant to Decrees of Russian President Boris Yeltsin No. 923, dated 15 August 1992, and No. 1334, dated 5 November 1992. The capital contributions to the Company were made in the form of property and shares of thermal and hydroelectric power plants, bulk transmission lines, dispatching control system, shares in regional energy companies, power sector research and development and construction businesses.

Thus, before 2008 RAO UES entities owned 72 percent of installed capacity of all power plants in Russia and 96 percent of the total length of all electricity lines. For 15 years, the RAO UES energy companies generated at least 70 percent of Russia's electricity and a third of heat in the country.

Since the Company's establishment, the key assets of RAO "UES of Russia" were consolidated in regional vertically integrated energy companies. 72 regional energos and AO-power plants were engaged in the generation, transmission and retailing of electricity and heat virtually in all constituent entities of the Russian Federation.

Before 2000, the electricity payments collection rate was very low, not more than 85 percent, with less than 20 percent of that amount paid in cash and the rest settled using promissory notes, set-offs, or barter deals. At the beginning of 1998, the customers' debt was in excess of RUB100 billion, which in turn led to a rapid increase in the RAO UES companies' accounts payable. The lack of funds caused various problems in the energy companies' operations: they experienced fuel shortages and wage arrears, all new construction projects were suspended, and repair operations were reduced.

In 1998, Anatoly Chubais was appointed Chairman of the Management Board of RAO "UES of Russia". The new managerial team that came to the Company included not only power engineers, but also economists, lawyers, and financial specialists,—that is, experts needed for successful implementation of a turnaround plan. RAO "UES of Russia" embarked on a financial recovery programme.

By 2000, the Company managed to ensure collection of 100 percent of electricity and heat payments from customers and to settle its tax debts and debts owed to suppliers. Within a very short timeframe, the Company managed to eliminate the imminent bankruptcies in some regional energos, pay wage arrears and stop the exodus of qualified personnel.

At the same time, the only source of finance for the Company's investment activities were energy tariffs set by the state. Their level did not allow the energy companies to renovate their production facilities and build new power plants and grids. The electricity industry was faced with an increasing depreciation and retirement of plant and equipment.

Despite all the problems, the RAO UES companies were able to supply power and avoid serious failures in electricity and heat supply.

RAO "UES of Russia" initiated the restoration of parallel operation of the energy systems in the former Soviet Union republics, a measure designed to improve the energy systems' reliability. Today, the UES of Russia runs in parallel with the energy systems in 12 FSU republics and exchanges electricity flows with the energy systems of Armenia, Norway, Finland, Poland, Slovakia, Hungary, Turkey, Iran, Afghanistan, Mongolia, and China. The project is nearing completion to produce a feasibility study on synchronous interconnection of the UCTE with the UES of Russia and the energy systems of the CIS countries and the Baltics which operate in parallel with the UES.

An important role in restoring the parallel operation of the UES of Russia and the FSU energy systems was played by the CIS Electric Power Council, which consists of officials in charge of energy authorities in the CIS countries. Since 2000, the Council is chaired by Anatoly Chubais, Chairman of the Management Board of RAO "UES of Russia".

The economic growth in Russia which began in 2000 led to an increase in energy consumption. Electricity demand in Russia grew by 2 to 4 percent annually. During the period from 2000 to 2007 it increased by 15.7% from 851.2 billion kWh to 985.2 billion kWh. The question arose whether the electricity sector was capable of meeting the challenge of supplying the needs of the national economy.

It became obvious that the sector was in need of large-scale investments, including private investments. In order to attract private investors, it was necessary to implement a reform of the entire electricity industry.

In 2000, RAO "UES of Russia" started consultations with the leading Russian and foreign experts, government authorities, members of the business community, and shareholders on the need for a structural reform, and the procedure for its implementation. As a state programme, the reform was launched in 2003, when a federal legislative package was adopted which governed the restructuring in Russia's electricity sector.

In the course of the reform, most of the regional energos were unbundled into generation, distribution, retailing and services companies. Eventually, these companies were consolidated to form interregional companies—WGCs, TGCs, and IDCs—and the regional energy retail companies started independent operations in their respective regions. Two principal infrastructure entities were created—Federal Grid Company, which consolidated bulk transmission networks and the UNEG, and System Operator, responsible for the dispatching function in the UES of Russia.

2003 saw the launch of a competitive trading segment on the Russian wholesale electricity market, a forerunner of the future full-scale competitive energy market. In less than a year, the Russian power exchange, which enabled RAO UES entities to practice and refine skills in a competitive environment, became one of ten world's major energy trading venues.

In September 2006, new rules for the operation of the wholesale and retail electricity markets were introduced. This became a major milestone in the development of competition in the sector. These rule made it possible to switch to a system of regulated bilateral contracts between the seller and purchaser of electricity. The electricity volumes not covered by the quotas of regulated contracts started to be traded at unregulated prices. The share of the wholesale market's liberalization was passed on to the retail market. The electricity price liberalization continued and in 2008 every fifth kilowatt is purchased at competitive prices. By 2011, it is anticipated that all electricity, excluding electricity supplied to households, will be sold at market-based prices.

The central idea of the reform was to enable private investors to operate in the competitive segments of the electricity industry while preserving public control over the sector infrastructure, which is a natural monopoly in nature. This idea began to be realized in 2006-2007 when the generation companies started selling their shares. Some WGCs and TGCs have already completed offerings of additional shares among private investors. Simultaneously, the Russian Government gave its go-ahead to the sale of the "government stake" shares in these companies held by RAO "UES of Russia". Private investors came to the sector, with investments by the end of Q1 2008 reaching RUB750 billion.

Thus, the structural reform in the electricity industry and the launch of a competitive market paved the way for the final phase of the reform designed to attract investments. One of the major results of the reform was the adoption and implementation of a five-year investment programme for the RAO UES companies for the period from 2006 to 2010, which envisages the creation of 29,000 MW of new generation capacity and construction of 70,000 km of HV transmission lines. The total amount of funds for this programme is estimated at RUB3.4 trillion, the greater part of which is to come from private investors.

Throughout the reform period, RAO "UES of Russia" remained a socially responsible company. A strong emphasis was placed on the social aspects of operations of the Parent Company and its subsidiaries, as well as the development of non-financial reporting in all RAO UES companies. As a result of these efforts, RAO "UES of Russia" moved up in the international and Russian CSR rankings.

Environment protection was another area given special attention at RAO "UES of Russia". Back in the 1990s, the Company had to face a number of environmental problems which emerged during the Soviet era. RAO "UES of Russia" is doing a great deal of work to modernize and upgrade the sector, improve fuel efficiency, develop renewable energy and introduce advanced energy technologies. In doing so, OAO RAO "UES of Russia" is engaged in an ongoing dialogue with the Russian and international non-governmental environment protection organizations which provide valuable input relating to the Company's environmental policy.

RAO "UES of Russia" was among the pioneers in implementing the Kyoto Protocol mechanisms in Russia. Long before the ratification of this global environmental document, RAO "UES of Russia" established an Energy Carbon Fund, an entity whose task was to create the necessary infrastructure and prepare for Kyoto Protocol-based projects. The Fund made a list of top priority projects to be implemented using the Kyoto Protocol mechanisms. In 2005, RAO "UES of Russia" entered, for the first time in Russia, into a contract for the sale of greenhouse gas emission reduction units with the Danish Environmental Protection Agency.

The completion of the restructuring, creation of the companies comprising the intended (post-reform) sector structure, and the need to promote genuine competition in the generation and electricity retailing business makes the very existence of the Parent Company, RAO "UES of Russia", redundant. The final phase of the reform envisages the reorganization of RAO "UES of Russia". During the process, 23 energy companies of the intended sector structure will be spun off from OAO RAO "UES of Russia", and the latter will cease to exist as a legal entity by 1 July 2008.

This date is provided in special amendments to the Federal Law On the Electrical Power Industry. Moreover, an important set of amendments was made to the Law regarding the control structure for the electricity industry after the reorganization of RAO "UES of Russia". This system will be based on two principles—raising the efficiency of government control and self-regulation. A greater part of the functions relating to government control will be transferred to the Federal Energy Agency of the Russian Federation. This authority will need to streamline the system of state control of the electricity industry, taking into account the huge changes that have taken place in the sector.

The Market Council is to become the basic element of the self-regulation in the electricity industry after the reorganization of RAO "UES of Russia" is completed. The Council will be created on the basis of NP "Administrator of Trading System" and will bring together representatives of all industry stakeholders involved—generation, grid, energy retail, and dispatching companies, as well as major power consumers.

By 2008, all necessary legislative and corporate resolutions had been taken for the performance of this step. By 1 July 2008, RAO "UES of Russia" will disappear from the country's economic landscape. It will be succeeded by OAO "System Operator of the Unified Energy System", OAO "Federal Grid Company of the Unified Energy System", OAO "HydroWGC", six wholesale generation companies, 14 territorial generation companies, 12 interregional distribution companies, regional energy retail companies, OAO "RAO Energy Systems of the East", and OAO "INTER RAO UES".

The fundamental changes that have taken place in the sector over the past 10 years were hailed by the investment community and stock market. By end-2007, the market capitalization of RAO "UES of Russia" was nearly USD50 billion compared to less than USD12 billion at end-1998. According to experts' estimates, the total value of the energy companies to be spun off from RAO "UES of Russia" is at least 40 percent higher than the value of the Parent Company. This is actually a premium to the shareholders of RAO "UES of Russia" who believed in and backed the electricity reform and will become shareholders in the companies of the intended (post-reform) sector structure after RAO "UES of Russia" is reorganized.

RAO UES STRUCTURE

AS OF 31 DECEMBER 2007

* the Company’s second-tier subsidiaries