Reforming the Company

DEVELOPMENT OF ELECTRICITY MARKETS

DEVELOPMENT OF COMPETITIVE MARKETS IN 2007

2007 saw continued operation and development of the system of electricity and capacity markets created in the autumn of 2006—the wholesale electricity (capacity) market which includes the day-ahead market, system of regulated contracts and balancing market, and retail electricity markets.

On 31 August 2006, the Russian Federation Government adopted its Resolution No. 529 On Improving the Operation of the Wholesale Electricity (Capacity) Market (the "Wholesale Market Rules") and Resolution No. 530 On the Approval of the Rules for the Operation of the Retail Electricity (Capacity) Markets During the Transitional Period (the "Retail Market Rules"), which became effective on 1 September 2006.

In early 2007, RAO "UES of Russia" and competent ministries and agencies started proactive efforts to produce rules and regulations designed to ensure stable functioning of the wholesale electricity (capacity) market and retail electricity markets. On 7 April 2007, the Russian Government adopted its Resolution No. 205 On Making Amendments to Some Instruments of the Russian Federation Government On Determining the Volumes of Electricity to be Sold at Free (Unregulated) Prices.

Further to the task set by the Government, the Russian Government adopted Regulation No. 951 of 29 December 2007 On Making Amendments to Certain Resolutions of the Government of the Russian Federation in Connection with Determining the Peculiarities of Functioning of the Wholesale Electricity (Capacity) Market During the Transitional Period in the Territories not United into Price Areas.

Resolutions of the Russian Government No. 450 of 16 July 2007 and No. 996 of 29 December 2007 provided for the following amendments to Resolution of the Russian Government No. 530 On the Rules of Functioning of the Retail Markets During the Transitional Period":

• the timings were changed for the first regular tenders to award the status of the guaranteeing suppliers;
• the final date for entering the wholesale electricity (capacity) market was changed for the guaranteeing suppliers that were not participants of the new market as of 1 September 2006;
• additional requirements were imposed for the purchase and sale of electricity between guaranteeing suppliers participating in the wholesale electricity (capacity market) and guaranteeing suppliers that do not participate in that market;
• the provisions changing (uniting or dividing) the borders of areas in which guaranteeing suppliers operate were revised;
• large generators located in the area of operation of a guaranteeing supplier not participating in the wholesale electricity market were permitted to sell their electricity, including to a neighbouring guaranteeing supplier participating in the wholesale market;
• a requirement was imposed on the guaranteeing suppliers not participating in the wholesale electricity market to sell the excess electricity produced by large generators located in their area of operation, to a neighbouring guaranteeing supplier participating in the wholesale market.

Order No. 135 of the Ministry of Industry and Energy of the Russian Federation, dated 23 April 2007, defined categories of consumers for which different terms were set for contracts to purchase electricity (capacity) at regulated prices on the wholesale electricity market.

With effect from 1 January 2007, regulated contracts were made on the wholesale market for 95 percent of electricity (and 100 percent of capacity) and were included in the aggregate projected balance for the generation and deliveries of electricity (capacity) for 2007 approved by the Federal Tariffs Service of Russia. The price set for each of such regulated contracts is the tariff set by the FTS for the generation company that is the supplier under the contract. For regulated contracts, each of the buyers is to pay the amount corresponding to the aggregate cost of electricity based on the indicative price for the purchase of electricity (capacity) on the market set by the FTS.

The number of regulated contracts made in 2007 was in excess of 13,500.

Resolution of the Russian Government No. 205, dated 7 April 2007, On Making Amendments to Some Instruments of the Government of the Russian Federation on Determining the Volumes of Electricity Sold at Free (Unregulated) Prices provides for a further reduction in the amount of electricity sold at regulated tariffs (prices) (as compared to the above aggregate projected balance for 2007).

Beginning on 1 January 2011, all electricity (except for supplies to household users) will be sold at prices not regulated by the state.

Deregulation of the retail electricity market is to be carried out in step with the wholesale market deregulation so that the market signals reach the end consumers of electricity and give them adequate information on the actual cost of electricity. This is needed to enable sound investment decisions to be taken and to provide incentives for implementing energy saving measures.

In this connection, new pricing principles for the retail market were included the Retail Market Rules. According to these principles, the part of electricity purchased by an energy retail company on the wholesale market at unregulated prices is to be paid by retail customers (except for household users) at the unregulated prices calculated by the retailer on a monthly basis. These prices must not exceed the unregulated price caps.

PACE OF ELECTRICITY MARKET LIBERALIZATION*

In 2007, unregulated prices for customers on the retail electricity markets were determined based on the following rules:

• For retail electricity users using a flat-rate tariff, the unregulated prices of electricity include part of the cost of the capacity which the guaranteeing supplier purchases on the wholesale market;
• For retail electricity users using a two-rate tariff, the cost of electricity purchased at unregulated prices, as before, does not include the cost of the capacity. The users pay for the contracted capacity in accordance with the rates set for capacity in a two-rate tariff.

Significant changes have been made to the capacity trading procedure on the wholesale market. If the actual capacity consumption exceeds the contracted capacity, excess use penalties are imposed.

On 1 January 2007, customers were made responsible for the deviation of the actual peak consumption from the planned consumption in the aggregate projected balance of electricity (capacity) drawn up by the FTS. As the volume of capacity purchased under regulated contracts was determined based on the volumes provided for in the aggregate projected balance, the differences between the actual consumption and the one projected in the balance result in the need to purchase the shortfall of capacity or sell the excess capacity, as the case may be. Such capacity is purchased or sold at prices set using the penalty factors determined by the FTS.

Markets Development Plans

In 2007, joint work with wholesale market participants was undertaken to improve the functioning of the wholesale electricity (capacity) market of the transitional period, including the following:

• the operations and financial results of the wholesale market participants were monitored on a regular basis;
• the rules for competitive trading in generation capacity on the wholesale market were drafted and submitted for approval to the competent ministries and agencies. Currently, the rules are under review at the ministries and agencies concerned.

Joint efforts with the competent ministry and agencies are underway to finalize the following documents:

• draft Resolution of the Russian Government on the creation of a mechanism to provide economic incentives for voluntary reduction in electricity consumption;
• draft concept and rules and regulations for the ancillary services market;
• draft procedure for identifying manipulations of electricity (capacity) prices on the wholesale market.

The establishment of a capacity market is an integral part of the electricity reform in Russian and the process to create competition on the wholesale electricity (capacity) market. Liberalized capacity trading is to be phased in by reducing the amount of capacity sold under regulated contracts and selling the remaining amounts through competitive processes, i.e. unregulated bilateral contracts and the competitive offtake of capacity.

The proposed model for competitive capacity offtake provides for execution of long-term capacity offtake contracts for several years ahead. These contracts may be made not only in respect of the existing power plants but also new construction projects, if the existing facilities are not able to accommodate the growing consumption according to the long-term consumption forecasts. By submitting offers to sell capacity once every several years, an entity planning to invest in the construction of new power capacity, will be guaranteed return of these funds if its offer is better than other investment projects. In order to implement the concept of competitive market for capacity, the competent ministries and agencies drafted and approved a draft of the resolution of the Russian Government which is expected to be adopted in 2008.

It is also planned to create a market for ancillary services which is one of the most efficient and effective instruments (mechanisms) for maintaining the required level of reliability and proper quality of functioning of the energy system.

Ancillary services include:

• services relating to frequency and active power flow control;
• services relating to voltage regulation and reactive power flow control;
• "launch from zero" and participation in control of automatic protective devices.

As a measure to prepare for the launch of an ancillary services market, pilot projects were determined for the provision of ancillary services, the amounts of services, and rules were produced for holding auctions to select ancillary services providers. It is expected that implementation of pilot services to provide ancillary services will be launched in 2008. The inauguration of the ancillary services market will help improve the reliability and quality of electricity supply to customers.

In the future, it is also planned to create a mechanism providing economic incentives for voluntary reduction of electricity consumption. It will provide for priority introduction of restrictions in respect of customers which enter into agreements on paid voluntary reduction of load during particular hours by pre-agreed amounts of capacity.

Implementation of the economic incentives for voluntary reduction of electricity consumption will help address the deficit of electricity capacity in some regions, especially during the peak load hours. For that purpose, rules have been formulated for introducing the mode and determining the extent to which the obligations have been performed, including the requirements for electricity metering equipment and payment procedure for reductions in consumption, etc.