Concept of RAO UESR's Strategy

Concept of RAO UESR's Strategy
for 2003 – 2008

The "5+5"

The Company reform framework was prepared in a 5-year period between 1998 and 2003. The Strategy assumes that the reforming of the RAO UESR entities will take 3 years and by 2006 all the key entities of the sector will be separated from RAO UESR. Following that, their full incorporation and completion of corporate procedures will take another 2 years. Thus, the target structure of the industry will emerge within a 5-year period (in 2008). These assumption is reflected in the subtitle of this document: "5+5".

The strategy outlined herein consists of proposals made by and views conveyed by the Company. Final decisions on most issues of restructuring of the sector and RAO UES of Russia will be taken by the RF Government, being duly authorized to do so in accordance with applicable legislation on the power sector.

The decision rendered by the RF Government will be subject to all corporate procedures instituted by RAO UES of Russia, including a motion put forth by the Board of Directors of the Company.

1.    Mission and Objectives of RAO UES of Russia

1.1 Mission of RAO UES of Russia

RAO UES of Russia, acting for the benefit of its shareholders, seeks to ensure a sustained growth of the value of its shares and the shares of the companies that will be established in the course of restructuring through a successful implementation of the reform and increased efficiency and transparency of its operations as well as the operations of the companies established in the restructuring process.

The key strategic elements for reaching this objective are:

• Management focus on reforms and concrete steps for their implementation
• Protect the rights of all minority shareholders during corporate reorganization
• Pay special attention to the development and implementation of a fair and transparent regulatory system for the operating of the transmission grid
• Improve corporate governance principles and ensure their compliance with the most advanced Russian and international standards
• Maintain and further develop the Company's market position in the heat and electricity markets
• Improve the Company's cost structure
• Improve the professional skills of the staff, social and labor environment
• Improve the Company's investment policy

1.2 Primary Goals and Objectives of RAO UESR Restructuring

• To ensure implementation of reforms at RAO UESR; to participate in the drafting of proposals for the RF Government in accordance with the RF laws and regulations concerning sector reform as to ascertain the full compliance with the requirements and goals set by the government; to guarantee the observance of rights and maximize the worth of the shareholders of RAO UES of Russia
• Provide reliable and uninterrupted electrical and heat supply to industrial consumers of RAO UES of Russia for the full transitional period
• Increase the market value of RAO UES of Russia and the new entities established in the course of restructuring
• Unbundle from the corporate structure of RAO UES of Russia during the course of restructuring efficient companies that are attractive to investors
• Improve current efficiency rates and develop core businesses of RAO UES of Russia
• Increase the Company transparency, further improve the corporate governance system, transform the Company into a business-oriented company
• Observe all rights and legal interests of the shareholders (RAO UES of Russia, its subsidiaries and associated companies), including minority shareholders

2.    General Goals and Objectives of Sector Reform, Legal Framework

2.1    Goals and Objectives of the Sector Reform

The primary goals of the power sector reform are:

• To increase the efficiency of power utilities
• To make the sector attractive to private investment

On the basis of the above, key objectives of the reform are as follows:

• To divide the sector into natural monopolies (primarily – 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 thus rendering natural monopolies attractive for investors

RAO UES of Russia will pursue the above reform goals, provided that:

• bona fide consumers of electricity and heat are guaranteed to enjoy reliable and uninterrupted power supply in the short- and long-term;
• a healthy balance is maintained between the interests of company owners, the State, and other parties, including consumers of goods and services produced by the sector and company employees

Sector reform has been stipulated by regulatory documents and is mandatory for RAO UES of Russia. The Company is one of the largest and most important subjects in the sector reform in the country, and it will take a pro-active stand in assisting executive authorities to further such reform, in forming specific models and mechanisms for its realization.

2.2 Legal Framework

Reform of the power sector of the Russian Federation cannot be consummated without an appropriate legal framework. In connection therewith, the RF Government has developed and submitted for approval to the State Duma a pack of draft laws regulating the reform of the power sector and RAO UES of Russia, which set the outline for future operating principles of the power sector in a competitive market environment and rigid control over government interference in economic relations.

The aforementioned set of draft laws includes the following draft federal laws:

• "On Electric Power Industry"
• "On the Entry into Force 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".

The above set of draft laws have been approved by the State Duma and the Federation Council of the RF and signed by the RF President.

In accordance and upon entry into force of the foregoing draft laws, economic relations in the electric power complex will take the following pattern:

Transitional Period

As of the moment of entry into force of the Law "On Electric Power Industry" (i.e. as of the date of its official publication) and until the wholesale market rules receive Governmental approval end enter into force (which is not anticipated before July 1, 2005), the power sector will operate under the conditions of a transitional environment. This period is required in order to streamline the organization of market mechanics with regard to business relations in the power sector and to secure consistent transition from the existing system of administrative regulation to the formation of a competitive environment. During this transitional period, the electric power complex will be geared toward operation under new conditions which propose a competitive organization of business relations whilst retaining the necessary level of administrative control in the sectors where creation of a market environment proves impossible. During this period, sector reform will proceed as follows:

- Change from vertically integrated utilities to business divided by activity

In the transitional period, there will be a full division between potentially competitive and natural-monopoly businesses in the power sector. Consistency of transition from vertically integrated companies to independently operating businesses will be achieved through a sequential, step-by-step separation process.

Thus, before January 1, 2005, all fields of business in the power sector will be distributed among stand-alone organizations. Such organizations will be created by way of reorganization of regional AO-energos. This will result in an organizational separation of generation, transmission, sales, system operator and repair agencies, as well as of non-core businesses.

A supplementary condition that will eliminate any future abuse of resources of the former integrated setup will be the prohibition of a simultaneous ownership of assets that are used both for natural-monopolies and for potentially competitive types of business.

As a result, the original setup of vertical integration at the regional level, based on organizational unity, will be replaced by a system of pooling business functions within the framework of management companies.

Henceforth, until the termination of the transitional period (which is not anticipated before July 1, 2005) the lines of business will be separated within the framework of affiliated person(s) (i.e. natural persons and corporate entities capable of having influence on business of corporate entities and/or natural persons engaged in entrepreneurial activities).

At the same time, in some instances, business mix in the power sector will be essential. In this respect, the right for concurrent engagement in monopolistic and competitive lines of business will be granted to the market participants that:

• operate within the frameworks of isolated power systems, provided that there is no or limited competition;
• are engaged in operational dispatch management and transmission of electric power solely for their own consumption;
• are regional grid companies with the status of a Guarantee Supplier.

Immediately upon the entry into force of the Law "On Electric Power Industry", those of its provisions become effective that determine the procedure for rendering services in electric power transmission and operational dispatch management.

Such measures will help consistent transition from integration to a system of market relations and will become a foundation for subsequent abolition of regulation in the areas of pricing and development of competitive markets.

- Introduction of the wholesale market to a system that combines free pricing and tariff regulation

Prior to the enactment of the Law "On Electric Power Industry" and its provisions that regulate the procedure for organization of business relations in the wholesale and retail electricity markets, the functioning of the markets will be governed by set of rules of the wholesale electricity market to be approved by the Government for the interim period. In this period, electricity will be sold on the wholesale market at both regulated tariffs, and at free prices. Quotas for sale of electricity at free prices will be determined by the Government for each participant of the wholesale market. The tariff regulation in the transitional period will be implemented in accordance with the effective Federal Law No. 41-FZ "On State Regulation of the Tariffs …" dated 14.04.1995, and to those areas that are not covered by this law, provisions of the Law "On Electric Power Industry" will be applied.

For the purpose of tariff regulation in this period, the Government will annually, before adoption of the state budget, establish electricity tariff limits. Interests of the general public therewith will be protected through approval of separate overall price levels for households.

- Final stage of forming new power sector players

The transitional period will see the organizational and property structure of new electric power market players taking the final shape.

Thus, before the end of the transitional period of reform (before entry into effect of the wholesale market rules approved by the Government), participation of the RF in the authorized capitals of the Unified National Electricity Grid Management Company and System Operator (that have by now been established as wholly owned subsidiaries of RAO UES of Russia) shall be secured at the rate of at least 52%.

Before the above share of the RF participation in the authorized capitals of the Unified National Power Grid Operator and System Operator has been secured, there shall be no assignment of their shares and/or assets (other than cash) contributed to pay up the authorized capital.

Henceforth, the RF will increase its stakes in the authorized capitals of the above companies by all legal means to at least 75% plus one voting share. Such higher stakes can be secured, among other methods, through cutting the RF's stakes in generation companies subject to a restriction prohibiting reduction, in the course of RAO UESR's reorganization, of the RF’s stakes (if such stakes are over 50%) in the authorized capitals of:

• joint stock companies owning, as proprietors or otherwise as provided by federal laws, hydro electric plants commissioned before the effective date of this Federal Law "On Electric Power Industry";
• organizations (or their successors) of which the above joint stock companies are subsidiaries.

During establishment of GenCos on the basis of power plants commissioned before commencement of the Federal Law "On Electric Power Industry", generating equipment comprising in the aggregate 35 and more percent of the installed generating capacity within the limits of the wholesale market price zone may not be included in the assets of any of the above companies.

Before July 1, 2005, the Supervisory Board of the Wholesale Market Trading System Administrator will have equal representation of the suppliers and buyers, with the representatives of the executive and legislative bodies also working on the Coordination Council.

- Replacement of tariff regulation by open pricing mechanisms

With the transitional period coming to an end (i.e. with the entry into force of the wholesale market rules), the wholesale and retail markets will be governed by the respective provisions of the Law "On Electric Power Industry".

As a result, the wholesale market will be provided with a mechanism of forming equilibrium prices within the price zones (the boundaries of these zones will be determined by the Government). The cornerstone of such mechanism is a system of price bids filed by suppliers and buyers (which may include zero-price, or price taking bids). Matching of the above bids (the amounts of electricity and price specified therein) provides a basis for the determination of the price at which electricity is bought and sold, as well as for the operational dispatch management.

In addition to the bidding system (i.e. spot market), there will also be a direct contracts market, the essence of which consists in electricity sales at the prices set by the parties (irrespective of the determined equilibrium price) on the basis of bilateral agreements. The entire trading mechanism will operate subject to a strict order of priority of loading generation facilities (primarily, the facilities that ensure system reliability and nuclear power plants, to the extent of securing the conditions for their safe operation; secondarily, thermal power plants, in the generation volumes corresponding to their operation in power-and-heat generation mode, and hydroelectric plants, in the generation volumes dictated by the technological and environmental safety considerations).

Upon expiration of the transitional period, electricity in the retail markets will be sold at prices formed by demand and supply.

Tariff regulation in the power sector will be retained in terms of regulating natural monopoly entities (to include the Federal Grid Company and System Operator). The state regulation will still apply in the following areas:

• regulation of prices (tariffs) of electricity and heat supplied in a non-competitive environment;
• regulation of prices (tariffs) for maintaining system reliability;
• regulation of prices (tariffs) of services of the trading system administrator;
• regulation of prices (tariffs) of heat;
• regulation of charges for connection to power grids;
• regulation of sales markups of Guarantee Suppliers.

In addition, the regulation of the limits (maximum and/or minimum) of electricity prices and the prices (tariffs) for available generation capacity will apply in cases of the emergence of monopolistic or oligopolistic tendencies requiring intervention of the state in the market pricing situation.

- Restriction of rights of transmission facilities owners

Upon expiration of the transitional period, legal powers of the Federal Grid Company will take their final shape in terms of disposal and control of the facilities incorporated in the Unified National Electricity Grid. In particular, a mechanism comes into operation that restricts the rights of transmission facilities owners who are members of the Unified National Electricity Grid. Thereupon, all contracts for electric power transmission involving the use of facilities incorporated in the Unified National Electricity Grid (irrespective of the owner) will be established by the Federal Grid Company. Also, the owners of such facilities may not undertake any action with respect to these assets unless there is explicit consent thereto of the aforesaid organization, except where the Federal Grid Company is in default on the terms of contract governing the procedure for utilization of the facilities incorporated in the Unified National Electricity Grid as set by the Government of the Russian Federation, and in other cases as determined by the RF Government. The owners of such facilities are guaranteed compensation in the amount they would be earning in case they were operating such assets on an independent basis, less the current costs incurred by the operator of the Unified National All-Russian Electricity Grid in connection with the operation of such assets.

- Formation of mechanisms ensuring dependable power delivery to the consumers in a competitive environment

The rights of electricity consumers for dependable power supply will be further secured by the formation of a guaranteed delivery system. This system will be comprised of organizations that have the status of a Guarantee Supplier and whose function is to ensure delivery of electric power to any applicant.

Support of the process of creation and development of the "guaranteed delivery" system in the power sector will be provided through establishment of a system of contracts (with the effective period of three years from the date of expiration of the transitional period) between the Guarantee Suppliers and the electricity suppliers who are members of the wholesale market. Terms and conditions of such contracts, including the starting price of electricity delivered thereunder, will be established by the Government. In due course, the delivery price of electricity supplied under these contracts is expected to gradually approximate the average price of electricity in the wholesale market. In such a manner, within three years from the date of expiration of the transitional period there will be a guaranteed possibility to ensure supply of electricity to households not at the market price formed in the wholesale market, but at the price of the Guarantee Supplier that will be based on the cost of electricity established by the Government and a regulated sales markup. As a result, the electricity price for households will not be affected by likely fluctuations of prices in the wholesale market.

In addition, in order to provide for dependable and uninterrupted power supply of individual groups of consumers served by the Guarantee Suppliers (this category will include the economically most vulnerable consumers, as well as consumers whose power supply is essential for reasons of national security), a mechanism will be created to offer electricity payment guarantees paid out of the state budget.

Implementation of the measures and processes described above will result in:

• reduction of the transitional period risks for all consumers and generators, smoothing out the potential dramatic fluctuations of the wholesale market electricity prices for the most economically vulnerable group of consumers;
• formation of a system of day-to-day state control over the progress of the reform;
• consistent transition from the existing system of management to competitive relations in the sphere of electricity turnover.

3.    Key Aspects of the Industry Reform

3.1 Target Structure of the Power Industry by 2008

It is assumed that by 2008 the restructuring of the power industry will be completed in all key respects. The wholesale and retail electricity markets will be entirely liberalized. The core transformations to be initiated by RAO UES of Russia in 2006 (separation of companies from RAO UES of Russia), including assuring direct holdings of RAO UESR's shareholders in spin-off companies, will be completed. By 2008, most of the generation companies should have become independent through a reduction of the government’s stakes.

As a result of restructuring of RAO UES of Russia and other utilities, the following players and ownership structure are expected to emerge:

• FGC - Federal Grid Company (the Unified National Electricity Grid)
• IDC - Interregional Distribution Company
• IDC’ – a RAO UESR's spin-off holding IDC's shares
• DC - Distribution Company
• WGC - Wholesale Generation Company
• TGC – Territorial Generation Company
• RGC - Regional Generation Company
• There will be the following industry players:

A. INFRASTRUCTURE ORGANIZATIONS:

Unified National Electricity Grid Management Company

The Federal Grid Company (FGC) is a company acting as a manager of the Unified National (all-Russian) Electric Grid (UNEG) for the purpose of assuring the integrity of UNEG technological management and rendering contractual services in transmission of electrical energy via the UNEG.

Fixed assets owned by OAO FGC UES are represented by virtually all the backbone grids of the Russian Federation (currently owned by RAO UESR holding company).

The FGC was created in 2002 as a fully owned subsidiary of RAO UES of Russia. By 2008, the Unified National Electricity Grid Management Company will have become an independent company separated from RAO UES of Russia and the owner of assets of the main transmission systems currently held by AO-energos, or stakes in the companies created on the basis of such assets. In the latter case the FGC will seek to create a unified operating company (through transition to a single share) provided that the government’s interest is not decreased.

The following options of АО-energos' transmission assets consolidation in the OAO FGC UES are proposed:

• OAO FGC UES buys out the transmission assets of the АО-energos (ITCs' shares held by them) at the market price using funds raised in the capital market or borrowed from the state. The servicing costs of the funds raised in the capital market are expected to be covered by incorporation of such servicing costs in the transmission tariffs.
• The state contributes funds into the authorized capital of OAO FGC UES, which subsequently buys out the transmission assets of the АО-energos (ITCs' shares held by them) at the market price. This option results in an immediate increase of the government's stake in OAO FGC UES.

In parallel, seven Interregional Transmission Companies (ITC) are established by way of the contribution of the transmission assets of АО-energos against the additional issues of ITC shares before the reorganization of АО-energos.

If OAO FGC UES is unable to buy out the assets (ITC shares), the reorganization of АО-energos will involve a separation of Transmission Companies (TC), holding the ITC shares as their only asset. After such separation, the TCs are liquidated (or merged into the ITCs), with the ITC shares being, as a result, distributed pro rata among the shareholders.

Following that, RAO UES of Russia will contribute its own ITC shares into the authorized capital of OAO FGC UES.

RAO UESR's management sees the prompt reforming of OAO FGC UES (including AO-energos' transmission assets) and its separation from RAO UES of Russia in the shortest term as its top priorities. The complexity of corporate procedures associated with this issue necessitates its further study and detailed review. Under certain conditions and subject to the assistance of governmental and regulatory agencies, the FGC UES separation from RAO UES of Russia may be possible before the reorganization of RAO UES of Russia.

After the separation of OAO FGC UES from RAO UES of Russia, under the Law "On Electric Power Industry", the government’s interest in OAO FGC UES will subsequently be increased by all lawful means to 75% plus one voting share, including through sale or exchange of the government’s stake in GenCos.

The main revenues of OAO FGC UES come as tariff for transmission of electric power via backbone grids. The prospective activities of OAO FGC UES (construction of new grids, long-term and complex projects), etc., can be financed with borrowings.

The crucial factor for the economic success of OAO FGC UES will be the establishment of a transparent regulatory and tariffication system, as well as the definition by the regulating authority of the fair Regulatory Capital Base (RCB) and fair rate of return on the invested capital.

Establishment of FGC as a major operator will ensure optimal liquidity and the capacity of raising loans, resulting in lower costs of capital and the corresponding containment of the tariff hikes.

System Operator

The system operator performs sole management of technological operation modes of the Unified Energy System of Russia and is authorized to give commands that are binding on all subjects of operational dispatch management.

OAO SO-CDU UES is created as a wholly owned subsidiary of RAO UES of Russia, and by 2006 it will have become an independent company possessing CDU, ODU, and RDU assets which are currently owned by AO-energos.

OAO SO-CDU UES buys out the RDU assets by borrowing funds in the market (estimated at about RUR1.5bn) – possibly, against a guarantee issued by RAO UES of Russia. The servicing costs of the loan in the capital market are expected to be covered by incorporation of such costs in the tariffs set by OAO SO-CDU UES.

Separation of OAO SO-CDU UES is expected to be effected through an unbundling during reorganization of RAO UES of Russia in 2005 or 2006. The stake owned by the state in the authorized capital of OAO SO-CDU UES will be at least 52%. Subsequently, the state will increase its stake in OAO SO-CDU UES to 75% plus one share through all legal means (including the exchange of its stakes in WGCs and TGCs for the shares in OAO SO-CDU UES).

In the event of simultaneous separation of OAO SO-CDU UES and OAO FGC UES from RAO UES of Russia, the Government of the Russian Federation may decide to merge the two organizations.

Interregional Distribution Companies (IDC)

Distribution companies created in the course of restructuring of АО-energos at the stage of their interregional integration will be merged into several (up to 5) holding companies (within the integrated energy systems) with sufficient assets and market capitalization. The ITC tariff will also be set on the basis of establishing a fair RCB (Regulatory Capital Base) and fair rate of return on the invested capital. It is envisioned that the RCB of every IDC should be at least US$0.5bn.

It is assumed that each IDC (a wholly-owned subsidiary of RAO UES of Russia) will take all the necessary steps for prompt transition to a single share (with the minority shareholders of DCs being invited to exchange their DC shares for IDC shares). As a result of such exchange, the share of RAO UES of Russia in IDCs may fall to a level not less than 49%, with the share of the IDCs in the DCs coming to 100%.

It is expected that in 2006 the reorganization of RAO UES of Russia will involve a spin-off of a company holding shares of all the IDCs owned by RAO UES of Russia. The Government's stake in such company will exceed 52%.

It is assumed that upon completion of all the principal activities in reforming RAO UESR holding company and setting up the target industry structure the government may take a strategic decision with regard to the disposal of stakes in the distribution companies based on the objectives of the governmental economic policy, providing, among other alternatives, for a possibility of privatization of the stakes owned by the state (through a sale or transition to a single share), subject to establishment of a regulatory regime ensuring a non-discriminatory access to the transmission facilities.

B. GENERATION COMPANIES

Wholesale Generation Companies (WGC) created on the basis of RAO UES of Russia

The WGCs (with an average installed capacity of about 9 GW) are the largest generators in the wholesale market. Ten wholesale generation companies are planned to be created on the basis of large federal plants owned by RAO UES of Russia: 6 WGCs will be formed on the basis of thermal generating facilities (thermal power plants), 4 WGCs on the basis of hydroelectric assets (hydroelectric plants). The list and configuration of the wholesale generation companies will be approved by the relevant Directive of the Government of the Russian Federation. Another option being considered is the inclusion in the WGCs of the hydroelectric plants (Bureiskaya HPP, Boguchanskaya HPP) currently under construction. In an effort to restrict the monopolistic influence on the competitive wholesale market of electric power, the wholesale thermal GenCos are formed on the basis of an ex-territorial principle while the hydroelectric plants are mainly based on a cascade principal.

In the first phase, WGCs will be created as ten holding companies (fully owned subsidiaries of RAO UES of Russia) by contribution to their authorized capital of shareholdings and property of power plants owned by RAO UES of Russia. WGCs can start to be formed prior to reorganization of АО-energos on the basis of assets held by the parent company, RAO UES of Russia, with subsequent increase of their authorized capital on account of the generation assets of АО-energos which are planned for incorporation into the WGCs.

An alternative option of establishing the WGCs which involves merging of the power plants intended for inclusion in a WGC into one of AO-plants, is lower in priority, since this process is rather lengthy (it might take some 1-2 years), and the full incorporation of WGCs in this case is only ensured upon completion of all the procedures involved in merging all the participating power plants.

In future, the TPP-based WGCs will become single-share integrated companies. To effect the transition of a TPP-based WGC to a single share, the parent company of the WGC, immediately upon the acquisition of stakes in all the AO-power plants intended for merging into it, will invite the shareholders of AO-power plants to exchange their stakes in such plants for the shares in the parent company of the WGC. Separation of WGCs from RAO UES of Russia will be possible only after the expiration of the validity period of the share exchange invitation. It is assumed that the power plants will be valuated for the purposes of the transition to a single share on the basis of the uniform business appraisal procedure approved by the Board of Directors of RAO UES of Russia, currently being developed by Deloitte & Touche.

After their separation from RAO UES of Russia (in 2006) all the hydro generation-based WGCs will have the form of production-financial holdings, with the capital structure of each parent company of the hydro generation-based WGCs being identical to the capital structure of RAO UES of Russia. The hydro WGCs may effect transition to a single share after such hydro WGCs are unbundled from RAO UES of Russia, subject to the government's stake in the capital of the single-share company being ensured at the level exceeding 50%.

The eventual objective is to reduce the government’s stakes in thermal WGCs by 2008 to zero.

Territorial Generation Companies (TGC) created on the basis of the companies of RAO UES of Russia

TGC (territorial generation companies) are the companies created on the basis of generation assets of АО-energos (save the plants incorporated in WGCs and isolated АО-energos) and consolidated on a regional basis. The list and configuration of the TGCs is established by a resolution of the Board of Directors of RAO UES of Russia. TGCs will be separated from RAO UES of Russia in 2006. In this context, after transition to a single share the separated TGCs will be either stand-alone operating companies or, perhaps, holding companies (after transition to a single share the government’s interest therein will be less than 51 %). It is assumed that the government will reduce its stakes in TGCs to have no TGC shares in its possession by 2008.

The TGCs will be formed on the basis of the principle of maximum aggregation of the new companies, while maintaining them in a configuration enabling free pricing in the wholesale electricity market. Base TGC incorporation option involves establishing a holding company, as a wholly-owned subsidiary of RAO UES of Russia, whose authorized capital includes the stakes in the regional generation companies (RGCs) owned by RAO UES of Russia. Immediately after their incorporation, the TGCs will invite the RGC shareholders to exchange their shares in RGC for the shares in TGC (parent company).

Following that, the TGC shareholders will be entitled to decide in respect of each individual RGC whether it joins the parent company of the TGC or the individual RGCs participating in the particular TGC merge between them. RAO UES of Russia, as one of the shareholders of these companies, is willing to support such activities.

A number of TGCs, apart from generating plants, will also include assets of heating networks and boiler plants. Also, integration with municipal enterprises in the field of heat supply is also possible. The TGCs can also incorporate supply divisions set for the purpose of business diversification with a view to financial hedging against price fluctuations in the electricity and heat markets.

Independent Generation Companies

Besides WGCs created with RAO UESR holding company's assets, the market players will also include nuclear power-based WGCs wholly owned by the state, and GenCos based on the assets of "independent" АО-energos (Irkutskenergo, Bashkirenergo, Tatarenergo, Novosibirskenergo).

Such greater number of independent generation companies by 2008 is an important priority for RAO UES of Russia because it is viewed as the main guarantee for effective operation of the liberalized electricity market and effective investment process.

C. SUPPLY COMPANIES

Holding of Guarantee Suppliers (GS) and isolated АО-energos

A Guarantee Supplier (GS) is a regulated business. In contrast to the competitive sales, the business of the Guarantee Supplier can be combined with the distribution business (distribution grids).

RAO UES of Russia is prepared (after approval of the relevant regulatory documents on the Guarantee Supplier) to agree to granting the status of a Guarantee Supplier to a number of supply companies separated from АО-energos.

It is assumed that most of the isolated power grids will have been restructured by 2008. However, some AO-energos isolated from the Unified Energy System will remain in 2008 vertically integrated companies, whose transmission, generation and sales business will be separated as wholly-owned subsidiaries.

After reorganization in 2006, RAO UES of Russia will be replaced by a holding company that owns shares in isolated АО-energos and АО-energos' supply spin-offs with the status of a Guarantee Supplier.

This holding company will also retain some shares in RGCs that stay within RAO UES of Russia – stakes in regional generation companies created as a result of AO-energos reorganization and not merged into the TGCs.

RAO UES of Russia will seek to minimize the number of RGCs staying within its structure in 2006.

The ownership structure of this holding company will be identical to that of RAO UES of Russia as of the moment of reorganization. The basic function of the holding company will be asset management, while dividends paid by the subsidiaries will be its source of revenue.

Competitive Supply Companies

Reorganization of AO-energos will entail the incorporation of competitive supply companies. It is assumed that they will perform the functions of GSs (unless otherwise decided by the state), and the basic pattern of activities a supply company established through the reorganization of a AO-energo will be functions of a Guarantee Supplier (unless otherwise decided by the state), pursuant to the rules and requirements established by the Government for such Guarantee Suppliers. In case such companies are not granted the status of GSs, they will engage in the competitive supply business.

Competitive supply companies will also be established by independent entities and will engage in the supply of electricity to the end users.

D. REPAIR COMPANIES

The target structure of the power sector as far as the repair and maintenance operations are concerned will be in place by as early as 2005. The target structure envisages an operation of a services market comprising independent repair and service companies operating in other sectors (including the metal industry, engineering, oil and gas sector) as well. The process of evolution of the repair services market players will be based on one of the following options:

A) spinning-off of the repair units as subsidiaries of АО-energos and AO-power plants with subsequent sale of stakes in such repair subsidiaries to the interested third-party customers;

B) at an option of minority shareholders of АО-energos – setting up separate repair companies in the process of reorganization of АО-energos, with subsequent sale of stakes in such repair companies owned by RAO UES of Russia.

It is understood that in some regions where an efficient repair services market is unfeasible, all the repair operations may be performed by the subsidiaries of the generation and transmission companies, as well as by the in-house units.

With regard to the subsidiaries of АО-energos specialized in rendering maintenance services for the transmission facilities, it is assumed that the stake of their shares is either sold or transferred to a distribution company to be established in the process of reorganization of the particular АО-energo, with subsequent consideration of its sale.

Along with the specialized repair companies, the repair services will be rendered by manufacturers of the power equipment, general-purpose engineering companies and other participants of this market.

E. RESEARCH AND DESIGN FACILITIES

Reforming the research and design facilities (RDF) aims at the establishment of integrated companies performing engineering tasks for the generation, transmission and other entities of the power sector as well as other industries (housing sector, big industry).

The target structure envisages the establishment by 2004 of seven regional technological centers (engineering companies providing full range of service, from diagnostics and design through acceptance testing, including the organization of the equipment supplies, vendor selection activities etc.), as well as the UES Engineering center geared to reconstruction and turnkey construction projects, expansion as such at the international markets, as well as domination at the related markets.

 3.2 Principles of Building Competitive Electricity Markets

When building an interactive model of the sector based on the best international practices of operation of competitive electricity markets, and considering the specifics of the Russian electric power industry, RAO UES of Russia will support the operation model of the competitive wholesale and retail electricity markets featuring as follows.

3.2.1 Competitive Wholesale Electricity Market (target model)

A single market space comprising the European part of Russia, the Urals and Siberia (save isolated power systems located in the above areas)

The wholesale market is based on commercial, free and competitive relations between the electricity vendors and buyers in selling and purchasing electricity. The need to accept the peculiarities of the current distribution of electricity within power system as a market restriction, and fairly strong interdependency among different areas of Russia, the necessity and efficiency of centralized management of power consumption modes dictates the shape of a single centralized wholesale electricity market in the European part of Russia, the Urals and Siberia (except for isolated power systems located in these areas). It is through this market that all electricity produced in these areas is traded.

The three sectors of electricity trading are as follows: the sector of long-term and medium-term bilateral financial contracts, the day-ahead market, the balancing market, and the power capacity market

The electricity market consists of three sectors that are separated in time but connected by their roles in formation of the final (actual) volumes of power production/consumption. These sectors are: the sector of long-term and medium-term bilateral financial contracts, the day-ahead market, and the balancing market.

What is accounted for in the process of the electric power sale and purchase in all of the above sectors of the wholesale electricity market are not only commercial preferences of the players, but also the feasibility of such preferences in mode management, as well as mode-dependent transmission losses of electric power. This accounting helps obtain the most accurate definition of the value of electric power at each point of electricity production and consumption.

Apart from the above three sectors of the wholesale market, a capacity market (or capacity charge) can be introduced to ensure additional stable medium-term revenues to the electricity generators when the situation requires additional encouragement of investments in the generation sector of the industry and smoothing of price fluctuations.

Market Infrastructure: TSA, SO and transmission companies

The key infrastructural organizations supporting the functioning of the wholesale market are as follows:

• The Trade System Administrator (TSA) that provides a central trading site for selling and purchasing electric power and supports its operation;
• The system operator (SO) and the regional dispatch units not included in the SO that provide operational dispatch management;
• The transmission companies that handle electricity transmission and take measures to reduce electricity losses, i.e. they collect payment for excessive electricity losses from companies responsible for such losses.

Market players and their mutual relations

All the electric power suppliers must operate on the market and offer the entire operating capacity of the generating units owned by them. Electricity buyers in the wholesale market are any end users and electricity resellers complying with the requirement of the minimum volume of electricity purchase, and the Guarantee Suppliers.

The requirements of the minimum volume of electricity purchase are defined by rates of growth of organizational and technological capabilities of the infrastructure to serve a growing number of players in the wholesale market.

3.2.2 Competitive Retail Market

The competitive retail market should have the following primary features:

• Freely set unregulated prices

Since the electricity supply companies and the Guarantee Supplier will purchase electric power in the wholesale market, where the price fluctuates irrespective of their individual behavior, a fixed retail price can lead to bankruptcy of the electricity supply companies and the Guarantee Supplier in the event the price of the wholesale market becomes higher than the fixed retail price.

• The end users' right to choose any seller to purchase electric power at free unregulated prices.

A competitive market should have instruments to hedge against the consumer's risk of power supply interruption because of loss, for whatever reason, of its electricity supply company, as well as hedging against the market risk related to unregulated activities of the electricity supply companies. Establishing a special institute of the Guarantee Supplier (GS) is one of the most important methods of such hedging.

3.2.3 Guarantee Supplier

The basic "market" function of the retail market GSs is to service the consumers which, for one reason or another, has failed to select their electricity supplier (they might be reluctant to take the risk, do not like the conditions offered, etc.), as well as "picking up" those consumers who has failed to find an electricity supplier (the electricity supplier is not prepared to serve them or has gone bankrupt, etc.).

With a view to ensuring efficient performance of the Guarantee Supplier's functions under the law, a system of direct contracts between the Guarantee Supplier and electricity suppliers for the volume of consumption by households and other socially important consumer groups (only them, rather than everyone who is served) will be introduced for the transitional period. RAO UES of Russia believes that the vesting contracts system should contain the following key components:

• the price level in such contracts should be stable enough, on the one hand, and on the other hand it should ensure a certain level of profitability for suppliers of electricity and services, which leads to a necessity to tie the prices in the contracts to the price level of fuel and other components of generation costs as well as the price level in the competitive electricity market;
• for buyers, the settlement conditions under such contracts may be softer than in the competitive market but still securing the interests of suppliers in terms of receiving payment for their product soon enough to support their efficient operation.

For all other consumer groups, the Guarantee Supplier will ensure the electricity supply at the prices of the competitive wholesale market, while setting a markup for its services the rate of which should be adjusted by the government.

3.2.4 Phases of Formation of Competitive Electricity Markets

Introducing competition in the segments of electricity generation and sales is a prerequisite of the efficient operation of the competitive wholesale and retail markets. Competition can exist only between the players that are not owned by (or not affiliated with) the same entity. If the government is the owner, then it is required that the management of their activities is decentralized.

It is impossible to fulfill this requirement throughout the area of anticipated functioning of the competitive electricity market within the period ending in 2005-2006, since re-structuring of Unified Energy System of Russia as the biggest monopolist cannot be completed in a shorter period of time.

In this connection, the company believes it necessary to launch a transitional model of the wholesale electricity market for the following reasons:

• implementation of the model will prepare the infrastructure and industry players for the fully competitive market;
• the competitive market practices will be tested in the actual financial settlements environment (rather than in a simulation mode);
• formation of market price signals to the investors based on the relative value of the generating capacities will begin;
• it will be possible to identify overlooked gaps in the model.

RAO UES of Russia supports implementation of the transitional model of the competitive wholesale market in several phases depending on the readiness of the sector's structure and other conditions.

DEVELOPMENT PHASES OF THE WHOLESALE MARKET IN RUSSIA

 PHASES OF DEVELOPMENT OF THE WHOLESALE MARKET IN THE REGIONS

Regional launching of a competitive wholesale and retail market as per the target model (100 % competitive market).

Concurrently with the operation of the 5-15 % market, it will be reasonable to prepare and implement a "small", but fully competitive, wholesale and retail electricity market as directed by the law and the target model.

This phase is necessitated by the need of practical trial of the target model in order to:

• forecast and mitigate any possible negative aspects of the fully competitive market model;
• develop a regulatory framework and verify its effectiveness;
• to field-test the fully competitive wholesale market

RAO UES of Russia believes that selection of the region where a successful introduction of such a market can be anticipated is an important point in implementation of this phase. This region should be small enough, but self-sufficient, and partly or completely isolated from the European Economic Community. The sector structure in this region (the basic players) should be potentially competitive.

The suggested starting date of this phase is April 2004.

In the event the sector structure is ready (there is a sufficient number of independent, competing players), launching of a fully competitive wholesale electricity market in one or several integrated energy systems will be possible.

3.3 Operation of the Transmission Business and Regulation in the Sector

In the process of reform, transmission and distribution grids will be transformed into independent companies. Transmission of electric power as a monopoly business will be regulated by the government.

The regulation objectives will be the following:

• provide non-discriminatory access for the market players;
• enhance operational efficiency of the regulated companies;
• guarantee financial stability and investment requirements of the companies in order to provide stable electric supplies.

The regulatory system of the sector in the natural monopoly and regional local monopolists environment dramatically differs from regulation in the market environment. So it is a must that the transitional period of the sector reforming should see (a) transition from the old to a new regulation system (breaking the old legal mechanisms and establishing new ones), (b) running control of the sector (at any time there should be effective regulating instruments).

RAO UES of Russia will stand for:

• formation of a strong and efficient regulator;
• building and implementation of an efficient and transparent tariff system based on the best international practices of regulation and promoting the efficient operation and cost saving of the regulated businesses;
• for the transmission companies, provision for establishment of a rate based on the definition of the Regulatory Capital Base (RCB) and establishment of an adequate rate of return on RAB, since it is deterministic for their ability to efficiently develop and enjoy an adequate market capitalization;
• technical assistance to subsidiary companies of RAO UES of Russia with methodology of setting-up tariffs with the Federal Energy Commission and Regional Energy Commission.

4.    Restructuring of RAO UES of Russia

4.1 Basic Principles of Restructuring RAO UES of Russia

1. The planned corporate change in RAO UES of Russia will be in accordance with the following priorities and limitations:

• Compliance with all the statutory requirements to companies in respect of liberalization of the energy market and proprietary relations in the power sector;
• Creation of an effective market environment, ensuring of the maximum transparency and efficiency of market mechanisms;
• Ensuring of economic and technical reliability of the energy and heat system;
• Safeguarding of the rights of all shareholders and creation of such conditions as would be required for growth in the value of their investment in the long term.

2. Implementation of all corporate transformations in RAO UES of Russia will be carried out in accordance with the following principles:

• Maximum possible consolidation of the established companies combined with ensuring efficiency for the business and shareholders and prevention of monopoly/oligopoly;
• Changeover, as soon as possible, to a single share system;
• Maximum protection of shareholders’ rights;
• Ensuring the transparency of the reform procedures;
• Guaranteed right to pro-rata distribution of newly established companies’ shares where a decision on reorganization is passed (by a simple majority of shareholders’ votes);
• Transparency and fairness of assets evaluation in dealings with assets;
• Retention of the amount and conditions of extinction of the reorganized companies’ liabilities vis-a-vis creditors;
• Fair and equal start-up conditions for newly established companies;
• Placing priority on quality rather than speed of transformations;
• Minimization of restructuring costs.

3. Mechanism of companies and assets separation from RAO UES of Russia

The basic unbundling mechanism for RAO UES of Russia will be proportionate distribution of shares. It is assumed that some WGCs will be separated from RAO UES of Russia through an arrangement involving the exchange of shares in the generating companies for the shares in RAO UES of Russia (with the shareholders retaining their right to a share in the stakes of WGCs owned by RAO UES of Russia equal to their share in the RAO UES of Russia proper). The Board of Directors of RAO UES of Russia may also decide to use other mechanisms for separation of its companies and assets (including tendering procedure) in cases of the single-consumer power plants as well as the plants located in isolated and closed power systems. The list of criteria for classifying CHP plants as single-consumer plants includes the following:

• Technological links through a common production infrastructure of the CHP plant and the consumer;
• Share of a single industrial consumer is at least 70% of the total heat generation of the plant;
• Share of industrial steam in the total heat generation being at least 70%.
• Another factor under consideration is the dependence of the electricity generation on the heat generation modes (use of back-pressure turbines, etc.).

These criteria are met by the following plants: Novgorodskaya CHPP-20 (Novgorodenergo), Kargalinskaya CHPP (Orenburgenergo), Argayashskaya CHPP (Cheliabenergo), Novomoskovskaya CPP (Tulenergo), Bogoslovskaya CHPP (Sverdlovenergo), Volgogradskaya CHPP-3 (Volgogradenergo), Kaluzhskaya CHPP-1 (Kalugaenergo), Tobolskaya CHPP (Tiumenenergo), with total installed capacity of about 1,600 MW.

It is expected that the Board of Directors of RAO UES of Russia will consider and adopt the decision-making procedure for the issue on a separate basis.

As far as the power plants located in isolated power systems are concerned, an analysis is currently under way, following which (within 3 months of the adoption of this Strategy) the Board of Directors of RAO UES of Russia will consider the list of criteria to be subsequently applied in the compilation and approval of the list of the power plants by the Board of Directors of RAO UES of Russia.

A list of the power plants will be submitted for consideration by the members of the Board of Directors of RAO UES of Russia on the basis of the approved criteria in respect of each of the above cases. The Board of Directors of RAO UES of Russia is expected to approve annually the list of the power plants for subsequent review of the situation involving each particular plant in order to consider its potential separation.

Total installed capacity of the power plants in isolated power systems included by the Board of Directors of RAO UES of Russia in the respective list will not exceed 700 MW.

The power plants, in respect of which the decision on the admissibility of the sale is adopted, may be incorporated as separate legal entities, following which the Board of Directors of RAO UES of Russia will consider the issue of the sale of the shareholding in such power plant owned by RAO UES of Russia. The inclusion in the TGCs of the generation facilities, in respect of which a special separation procedure is adopted, shall be decided by the Board of Directors of RAO UES of Russia on a case-by-case basis.

It is important to note that the particular consumer takes on, along with the generation assets, the liability concerning the electricity and heat supplies to other categories of consumers (primarily, supply of heat to the households).

Shareholders of RAO UES of Russia will have access to the materials (including the opinions delivered by independent experts) used by the Board of Directors of RAO UES of Russia to substantiate its specific decision deviating from the overriding principle.

All the separation mechanisms will be applied in accordance with the international practices, the transparency principles and the stringent observance of the shareholders' interests during both the assets separation and the income distribution.

The Board of Directors of RAO UES of Russia will consider and adopt the procedures and mechanisms of the distribution and application of the proceeds of sale of the assets.

It is assumed in any case that the sale option will be considered in respect of facilities selected with the use of criteria developed and approved by the Board of Directors of RAO UES of Russia. All such deals will be considered individually with the use of a mechanism approved by the Board of Directors of RAO UES of Russia.

4.2 Reorganization of RAO UES of Russia (Parent Company) and its Subsidiaries (AO-energos)

A. Reform of RAO UES of Russia (Parent Company)

It is proposed that restructuring of RAO UES of Russia parent company will be carried out in two stages:

At the first stage RAO UES of Russia divests several fully incorporated WGCs based on the heat-generating assets using a procedure involving the exchange of the shares in generation companies for the shares in RAO UES of Russia.

The arrangement involving the separation of the GenCos from RAO UES of Russia is intended to achieve the following:

• Secure an increase of the state's stake in RAO UES of Russia (primarily, in the transmission assets);
• Establish independent WGCs which is expected to speed up the liberalization of the wholesale electricity market;
• Secure opportunities for additional participation in the generation assets for all the interested shareholders of RAO UES of Russia until the moment of reorganization of RAO UES of Russia and the full launch of the market.

To this end, it would be expedient to carry out an exchange of the shares in RAO UES of Russia for the shares in WGCs (their parent entities) with subsequent retirement of RAO UESR's shares and reduction of the authorized capital of RAO UES of Russia. It is expected that the state doesn’t take part in the exchange, which will result in an increase of the state's stake in RAO UES of Russia and, subsequently, in all the companies (including OAO FGC UES and OAO SO-CDU UES) which are separated in the process of reorganization of RAO UES of Russia.

To enhance the transparency and use of well-tested technical trading solutions, it is proposed that the transaction of the exchange of RAO UESR's shares is conducted through a specialized agent (an investment bank with international name and a record of successful completion of such transactions, in the international and/or in the Russian market). The investment bank is to be engaged by RAO UES of Russia on a competitive basis.

Proposed stages of the shares exchange:

1. "Proportional exchange". All shareholders of RAO UES of Russia will be entitled to exchange part of their shares in RAO UES of Russia for the shares in the separated WGCs and thus to receive an interest in the WGCs' stake owned by RAO UES of Russia equal to their stake in RAO UES of Russia proper before the exchange transaction. The proposed exchange ratio will be established by the Board of Directors of RAO UES of Russia.

2. "Auction". WGCs' shares uncalled by the shareholders of RAO UES of Russia within the framework of the "Proportional exchange" will be sold through an auction. Payment instrument at the auction will be RAO UESR's shares (with the minimum exchange rate to be the rate established by the Board of Directors of RAO UES of Russia for the "Proportional exchange").

Prior to the first exchange of shares in thermal WGCs for the shares in RAO UES of Russia, the Board of Directors of RAO UES of Russia will adopt an exchange transactions schedule (including, among other things, a list of the WGCs intended for participation in the exchange scheme), and will make decisions concerning the specific procedures for such exchange. The procedure adopted by the Board of Directors should aim to give a chance of participating in the auctions for all the shareholders of RAO UES of Russia irrespective of their shareholdings.

 Safeguarding the right of the WGC shareholders to offer their shareholdings at the "Auction" along with RAO UES of Russia (tag along)

Exchange transactions may take place after the minority shareholders of the WGC subsidiaries (if any) have been offered to effect transition to a single share in the WGC. Separation of a WGC from RAO UES of Russia is allowed only after the expiration of the validity period of the share exchange proposal. The shareholders agreeing to the transition to a single share in the WGC are entitled to offer their shares at the "Auction".

Upon the completion of the exchange transactions a resolution is passed on the reorganization of RAO UES of Russia and a separation of the following entities:

• Unified National Electricity Grid Management Company holding 100% of shares in OAO FGC UES.
• May be some other companies of the sector which have been fully incorporated by that time (including OAO SO-CDU UES, WGCs, TGCs, etc.).

RAO UES of Russia will seek to accelerate incorporation of АО-energos' transmission assets into OAO FGC UES as much as possible and to separate OAO FGC UES from RAO UES of Russia in the speediest manner possible.

At the second stage, which is expected to commence about the Q2 2006, at the latest, resolution on reorganization of RAO UES of Russia will be adopted, providing for the separation of the following entities:

• Entities holding shares in some thermal WGCs retained by RAO UES of Russia at the moment of reorganization (each company is separated independently);
• Entities holding shares in the WGCs established on the basis of hydroelectric plants (each company is separated independently);
• Entities holding shares in fully incorporated TGCs – irrespective of the transition to a single share (each company is separated independently);
• Entities holding shares in all (up to 5) IDCs.

The holding company that will replace RAO UES of Russia will hold the stakes in Guarantee Suppliers, isolated АО-energos, non-consolidated RGCs and other non-core and service assets of OAO RAO UES of Russia.

All the entities which have been separated from RAO UES of Russia and which hold shares in core companies, such as OAO FGC UES, WGCs and RGCs will later be either liquidated or affiliated, so as to ensure direct participation of RAO UESR's shareholders in the capital of the core companies.

 B. Division of AO-energos by Lines of Business

Division of each AO-energo by the line of business will be carried out in two stages:

 Stage 1. Sale by AO-energos of the transmission assets to OAO FGC UES or participation of АО-energos in ITCs, assignment of property and functions of RDU to OAO SO-CDU UES and establishment and sale of repair, service and non-core companies.

 Stage 2. Restructuring of AO-energos through separation of companies by the line of business with proportionate distribution of shares among shareholders of reorganized AO-energos:

• regional generation company (to operate generation assets, heating networks and boiler plants)
• distribution company (to operate distribution grid assets)
• transmission company holding shares in ITC
• supply company
• repair companies (at shareholders' option)

In some AO-energos, the following entities will also be separated:

• GenCos based on the plants to be included in WGCs,
• thermal companies (in some regions, based on heating networks and boiler plants).

In the course of restructuring of AO-energos, the unity of management of spin-offs will be provided throughout the transitional period (up till interregional integration). Such unity of management will be ensured through establishment of management companies – either the wholly-owned subsidiaries of RAO UES of Russia operational until the restructuring of AO-energos is completed or companies separated from АО-energos.

Other options ensuring the division of AO-energos by lines of business are also possible in case the Board of Directors of RAO UES of Russia decides to proceed with a particular restructuring project on a case-by case basis. The options considered are only those entitling each shareholder to a proportional share in the entities established in the process of the restructuring. RAO UES of Russia will be receiving a proportional share in all the entities established in the process of restructuring of АО-energos equal to the share of RAO UES of Russia in every restructured АО-energo. During the preparation of the restructuring project and adoption of the decisions concerning the reorganization of АО-energos, RAO UES of Russia will not assume any additional liabilities resulting from the subsequent exchange transactions involving the exchange of the shares in the companies established in the process of reorganization of АО-energos for shares in other companies.

Restructuring of AO-energos is expected to be carried out in three stages:

 Stage 1. Restructuring of pilot AO-energos (2Q03–2Q04). Upon completion of that stage, analysis of the procedure for restructuring of AO-energos will be carried out and amendments thereto made to enhance its efficiency.

 Stage 2. Restructuring of the second group of AO-energos (this process starts subject to affirmative shareholders' meetings of pilot AO-energos and with consent of the minority shareholders): 3Q03–3Q04.

 Stage 3. Restructuring of the remaining AO-energos (4Q04–3Q05). Some AO-energos will be restructured on the basis of the statutory provision that permits passing of restructuring decisions by a simple majority of votes (which involves proportional allocation of shares of the established companies to the shareholders of the restructured АО-energo) – such provision will come into effect on January 1, 2005.

5    RAO UESR Holding Optimization and Development Strategy

 For the purposes of further development and raising its operational efficiency in the period of 2003-2005, RAO UESR Holding will primarily:

• Improve the policies of RAO UES of Russia in the heat and electricity markets,
• Raise the efficiency of internal policies and practices at the holding businesses.

5.1 Improving RAO UESR's Policies in the Heat and Electricity Markets

The position of the companies incorporated in RAO UESR Holding in the heat and electricity markets over the recent period and in the immediate future is characterized by the following main trends:

• Some decrease of the share of RAO UES of Russia in the electricity generation balance due to the strengthening of the position of "independent" electricity generators, Rosenergoatom, Irkutskenergo and others;
• Slight drop of RAO UESR's share in the sales of electric power to large consumers as a result of the major industrial consumers' turn to buying electricity in the FOREM because of inflated tariffs set by the regional authorities (due to a considerable extent of cross-subsidizing practices);
• A trend towards decreasing outputs of the heat energy at RAO UESR's generation facilities as compared to 1991, resulting from: a) industrial slump in the country since early 1990s, b) energy-saving actions by the consumers, c) large-scale installation by the consumers of in-house heat generating facilities due to the non-competitive tariffs set by RAO UESR's utilities as well as the policy of preserving the cross-subsidizing practices pursued by regional regulators;
• Absorption of the municipal resellers of heat and electricity by the entities of RAO UESR Holding in the form of a) interception of supply functions; b) physical acquisition of companies/assets (generally, on account of the debts accumulated by the municipal enterprises and local authorities).

RAO UESR's policy will aim as at strengthening positions of the Holding businesses and expansion of their market share, so at increasing the profitability of the existing businesses.

To forestall a decrease in the market share of the Holding Company's entities, RAO UES of Russia will be pursuing the policies of elimination of the cross-subsidizing practices. Task set before the AO-energos is to create the most attractive terms of supply of heat and electricity to major industrial customers. This task can be achieved by streamlining the tariff-based regulation as well as increasing current operational efficiency of the companies.

The acquisition of municipal heat generation, distribution and supply entities is seen by RAO UES of Russia as a business decision which should only be taken subject to enhancement of profitability of the newly established as well as existing assets of the companies. Expansion of the market share and increase of the profitability of CHP generators through the acquisition of heat generation and distribution assets will be conducted by the companies of RAO UESR Holding on the basis of two business objectives:

• Hedging of the operational risks of CHP generators (utilization of the power plants capacity);
• Expansion of business through the absorption of heat-generating companies (including those technologically unrelated to AO-energos).

Expansion of the share of electricity market in the retail sales by the absorption of the wholesale resellers on the basis of the existing legal and competitive opportunities aims at facilitating the formation of a single energy distribution infrastructure, improving the supply opportunities for the end users, improving the company's profits through extensive growth and gaining efficiency from the resulting economies of scale.

Acquisition decisions with respect to particular entities will be based on comprehensible and transparent business criteria (payback period, rate of return, operational efficiency, etc.).

Another area of business growth of the corporate members of RAO UESR Holding is the small-capacity sector, where the development should be directed towards the expansion of the market and business share in the sector.

International and transnational projects in the context of integration processes (within Europe-Asia Energy System, with CIS and FSU, as well as European Union countries) will be based on terms ensuring economic efficiency.

5.2 Raising the Efficiency of Management, Business Processes and Corporate Governance in RAO UESR Holding Company

5.2.1 Cost-Saving Program of the Corporate Members of RAO UESR Holding and the Divestiture of Non-Core Operations

Sustained cost-saving activities in the corporate entities of RAO UESR Holding is a priority area of the company strategy. By the end of 2003, it is planned to develop and adopt a new Cost Management Program providing for a substantial reduction of costs in 2004-2006.

 Cost reduction actions within the comprehensive Program on cost management. The main areas of cost saving are as follows:

• Activities aimed at reducing the fuel costs: improvement of fuel supply policies (in particular, by singing comprehensive large-scale contracts on behalf of the parent company), use of the domestic energy resources exchange (gas and coal supplied within the contract limits), use of financial instruments to hedge against price fluctuations;
• Establishment of a competitive market of the basic repair and maintenance services: spinning off the Holding Company's repair and maintenance operations, cutting the repair costs, reducing the repair and maintenance labor force, expanding the tender-based procurement procedures;
• Increasing the labor productivity: optimization of the staffing levels and deployment of new technology and equipment;
• Focusing on the core business and divesting the non-core assets (on the most profitable terms).

The cost-saving measures implemented by RAO UES of Russia and AO-energos will be coordinated with the regulator, in order to apply the saved resources to the development of the business entities.

RAO UES of Russia intends to report to its shareholders on the progress of implementation of the cost-saving program on a semiannual basis.

 Improvement of the financial management system, primarily:

• More efficient payables and receivables management: more rational application of internal and borrowed funds (more active use of cheap credit resources for profitable projects), writing off bad debts;

5.2.2 Measures for Reduction of Electricity and Heat Losses in the Generation, Transmission, Distribution and Supply to End Users

Calculation of losses and any measures to manage them are only possible when (1) there is a possibility of their accurate measurement and control at all stages, (2) areas of responsibility for each link of the production chain are clearly defined.

Principal measures to ensure the reduction of technical losses include technical audits, preventive maintenance, installation of modern high-technology equipment.

Principal measures to ensure the reduction of commercial losses include timely internal audits, field inspections at the end user facilities, improvement of the accounting systems, automation and introduction of information technologies.

One of the key measures that are aimed to raise the efficiency of loss management activities of the Holding Company (being a necessary prerequisite for the efficient operation of the electric energy market) is the implementation of state-of-the-art electric and heat energy accounting systems.

• Commercial and technological accounting systems (Automated Commercial Energy Accounting System and Automated Technological Energy Accounting System) will:
• Help identify the causes of energy losses;
• Ensure consistency of the accounting principles,
• Ensure greater speed of delivery of accounting data,
• Help split the accountability for the dispatched vs. consumed electric energy.
• Principles of application of accounting systems:
• To identify losses in the particular sections of the system, splitting the accountability between the specific business entities and in the energy system as a whole;
• To calculate and monitor the balance of capacity and energy, split by particular units.
• Policies of the accounting systems implementation:
• To bring the systems closer to the end users.

5.2.3 Investment Policies of RAO UESR Holding

It is important to note that in the preceding period the investment policies of RAO UES and its affiliated companies were fully controlled by the state and aimed predominantly at meeting technical requirements rather than ensuring business performance. Principal source of finance for the projects were the funds invested directly into the tariffs of the Holding Company members.

The investment policy of RAO UES of Russia focuses, primarily, on the maximization of the efficiency of the Holding Company's own investments and securing sufficient capacity in the Russian power sector for the transitional period by mobilizing the capital of external investors.

As far as the Company's own investments are concerned, it should be stressed that this policy is dictated to a significant extent by the need to complete a number of construction projects started by the state as early as 1980s and funded in the amounts which were insufficient for their commissioning to the established deadlines. Funds for the construction of such facilities are incorporated in the subscription fees and approved by the governmental bodies.

The Company calculates economic ratios for all its investments (rate of return, payback period) applicable under different electricity prices scenarios. In addition, the Company has introduced a strict system of financial controls and procedures for planning the investment volumes.

Unfortunately, commissioning of all the facilities under construction may prove inadequate to resolve the power balance problems in the near future. Even assuming certain current surplus of capacity and the facilities to be installed in the next 3-5 years, the estimated decommissioning of the obsolescent facilities brings up the issue of the need to introduce new capacity before 2007-2008. Under the optimistic scenario of overhaul renewals in the unified electricity grid of Russia (UEG of the North-West, Central Region, Middle Volga region, North Caucasus and Urals) by 2007 the total deficit may reach 7-8 thousand MW.

Therefore, it is high time to embark on investment projects ensuring the commissioning of the required capacity in the above timeframe. The completion of the power facilities selected by the Government of the Russian Federation before the end of the transitional period of the power sector reform is expected to be funded from the revenues of RAO UES of Russia from subscription fees.

For all its new projects (those currently initiated), RAO UES of Russia establishes a system of business indicators (rate of return, payback period, profitability rate, etc.) serving as a basis of assessment of all the proposed projects. These indicators will reflect the business priorities of the company and will be made available to its shareholders.

RAO UES of Russia also intends to proceed to a more extensive use of borrowed resources for the implementation of investment projects in order to achieve optimal leverage ratios.

In the period leading to 2006, a certain proportion of investment projects ("old" construction sites) will be financed directly through their tariffs, which, obviously, may be out of line with the business criteria of the company.

Transition to the 100% market-based investment mechanisms and attraction of private investors into the electric power sector will be conducted in stages.

Electricity market could also be introduced as one of the investment incentives as well as a means of reducing the market volatility, since the completion dates of the new facilities construction and payback periods in the power sector are substantially greater compared to those in other industries.

5.2.4 Improving Professional Skills of the Staff and Quality of Corporate Governance in RAO UESR Holding

 Setting new objectives places new demands on the staff, as well as the human resources management system in the transitional period for the industry.

RAO UES of Russia strives to build highly-skilled management teams professionally involved in the current management of the companies, bringing international experience into their operations and directly motivated to accomplish the objectives set before them.

One of the principal elements of the policies aimed at raising the quality of management in RAO UESR Holding will be invitation by member entities of managers with a track record of employment in foreign energy companies.

It is also planned to actively pursue programs helping the staff to adapt to the changes of the transitional period: knowledge transfer, secondments to successful facilities of the industry, professional skill certification, staff competences management programs.

To maintain the levels of professional competence of the management staff of its member entities, RAO UESR Holding will conduct training of the management staff, including training courses for management teams conducted at its corporate educational and research center.

RAO UES of Russia is already making active use of the incentive schemes for the top management of its subsidiaries aimed at greater production efficiency, profitability and manageability of these entities. In the future these schemes will be further improved.

Areas of improvement of the social and labor environment in RAO UESR Holding Company

RAO UES of Russia adequately appreciates the importance of productive, mutually beneficial and responsible relations between the corporate entities of RAO UES of Russia and their personnel for the Company's shareholders, the consumers and the state.

RAO UES of Russia stands for:

• further advancement of the social partnership in the field of labor;
• fair evaluation and compensation (among other things, by implementing a special Incentives Program) of the contribution of each employee of the Holding Company entities, respect of their dignity;
• joining employers' efforts in the context of the All-Russian association of employers of the power industry.

 5.2.5 Use of Depositary Receipts for the Shares in the Holding Businesses During the Reform

RAO UES of Russia is fully aware of the need to launch depositary receipt programs for large companies established in the course of restructuring RAO UES of Russia, subject to the statutory mechanisms of the Company reorganization. To ensure the liquidity of the market of shares issued in the process of restructuring large companies (FGC, IDCs, WGCs, RGCs, GS holding company and isolated AO-energos), their shares (as well as the depositary receipts for their shares) will be offered for trading in the domestic and foreign organized markets, subject to meeting by the companies of the listing requirements of the respective exchanges.

In this regard the management of RAO UES of Russia will be actively participating in introducing the new companies to the stock trading systems (both in Russia and abroad), including intensive work with the management of these companies (training, secondments etc.) and the investment community (meetings with analysts, roadshows etc.).

With respect to the current holders of the depositary receipts, one of the following scenarios may hold:

• Depositary receipts are kept as an instrument under one of the chosen schemes of transformation of the current depositary receipts programs. Management bodies of the new companies sign depositary agreements with a depositary bank. Depositary receipt holders receive depositary receipts of new companies;
• Depositary receipts are kept as an instrument under one of the chosen schemes of transformation of the current depositary receipts programs. Management bodies of the new companies don’t sign depositary agreements with the depositary bank. The depositary bank issues depositary receipts without the companies' consent fully on its own account, the program taking a "non-sponsored" status. Depositary receipt holders receive depositary receipts of the new companies, but the companies assume no liability with respect to such instruments;
• Depositary receipts are cancelled. Depositary receipt holders become shareholders in the companies and receive shares of the new companies through the depositary bank;
• Depositary receipts are cancelled. The depositary bank sells the shares of the new companies at an auction and distributes the proceeds of sale among the depositary receipt holders.

Consultations held with the depositary banks showed that the depositary receipt programs for the new companies are quite feasible in procedural and technical terms. The matter of the preservation of the Program and selection of its specific transformation option will be agreed upon with the depositary banks and the holders of the depositary receipts of each company.

5.2.6 Improvement of Corporate Governance Standards in RAO UESR Holding

Enhancing capitalization and ensuring the liquidity of the shares of companies established in the process of RAO UESR reforming is impossible without an efficient corporate governance system (system of relationships between the companies' shareholders, members of the boards of directors, management boards as well as other interested stakeholders) in each of such companies.

In view of the above, the operation of the companies will be based on internationally accepted principles of corporate governance, as reflected, in particular, in the OECD Corporate Governance Principles. Further development and implementation of these principles will be reflected in the Corporate Governance Code of RAO UES of Russia.

In the process of the industry reform the administrative management methods will be replaced by corporate management methods, based on the most advanced governance standards employed by Russian and international companies listed in the leading stock exchanges.

RAO UES of Russia will strive to increase the efficiency of operation of the collective management bodies - primarily, of the boards of directors of the Holding Company members (assistance at the level of the parent company and ensuring such operation in the subsidiaries and associated companies), by the following means:

(1) Setting up an efficient system of authority distribution among the managerial bodies of the companies – general meetings of shareholders, boards of directors, general directors and collective executive management bodies

A board of directors operates as a collective management body concerned with the strategic issues of the company's management. General directors and management of the companies are responsible for efficient management of their day-to-day activities.

(2) Development of the institution of professional members of the boards of directors

Professional members of the boards of directors will be engaged on a permanent basis in the activities of the companies in the areas where a role of a high-status representative of a company is required. Development of this institution will involve, among other things, wider authority of members of the boards of directors.

(3) Raising the number of independent directors on the boards

Corporate governance practice of engaging independent directors on the boards of directors serve as an indication of better level of governance of the companies, as well as greater confidence of potential investors in the company.

(4) Establishing advisory and special-task bodies – committees, working groups etc. – attached to the boards of directors

These collective bodies (along with the already existing Reform Committee and the Appraisal Committee of the Board of Directors of RAO UES of Russia) will be set up with the purpose of organizing and coordinating the activities relating to the most complex tasks and projects relating to the authority of the boards of directors and followed up at their meetings. It is advisable that the bodies attached to the boards of directors are managed by professional and independent members of such boards. Another proposed advisory body is an Audit Committee (to be responsible, among other things, for the monitoring of compliance with the "Guidelines for the execution of securities transactions by members of the Board of Directors and Management Board of RAO UES of Russia") and the Compensation Committee (with the development of the Incentives Program for the management of the corporate entities of RAO UES of Russia as one of its primary functions).

(5) Regulations governing the information policy of the company

• Accountability of the management to the board of directors is implemented through periodical reports on the results of the current operation, delivered in the context of the authority distribution among the management bodies;
• RAO UES of Russia will continue its practices of information disclosure in accordance with the Russian law, as well as the preparation of accounting statements under IAS;
• The information policy will establish the rules of information exchange of the members of the boards of directors and managers with the general public;
• The information policy will envisage the responsibility of members of the boards of directors and management staff for any damage caused to the company (including an injury to goodwill) as well as the disclosure of corporate, commercial and state secrets.

5.3 New Core Business Areas in RAO UESR Holding

Further to the development and enhancement of business associated with the key production assets of the member entities of RAO UES of Russia, the member companies also intend to develop operations in the related areas, securing a significant share of the market.

Participation in transformation of the housing and communal services system

Participation in the housing and communal services business is defined by the management of RAO UES of Russia as a new strategic area of the Company's development. The housing and communal services business is a natural extension of the core business of RAO UES of Russia ("last mile").

The problems faced today by the housing and communal services sector are much similar to those faced by RAO UES of Russia several years ago. RAO UES of Russia has accumulated experience of successful resolution of such problem (arrears on payments, etc.). If this experience is applied successfully, we may be confident that the housing and communal services sector may be transformed into an efficient and profitable segment of RAO UESR's business.

 Foreign markets

RAO UES of Russia also plans to increase its presence abroad, primarily, in the CIS countries. Especially attractive are the business opportunities related to the repair and operation of enterprises in the power sector.

 Small-capacity generating sector and the alternative sources of energy

Members of RAO UESR Holding Company intend to increase their involvement in the low-capacity generation business as well as the use of alternative sources of energy ensuring greater (compared to the traditional sources) environmental performance and safety of production processes: in the sale, installation and maintenance of small-capacity power plants using both traditional and non-traditional sources of energy, generation of electric and heat energy using such facilities, in particular, by core business units of regional generation companies established in the process of AO-energos restructuring. These activities will help secure participation of the Holding Company members in electricity supply across the Russian Federation territories not covered by the UES.

As other areas of the company's business development are elaborated, they will be considered and approved by the Board of Directors of RAO UES of Russia.

6    Stages and Mechanisms for Implementation of RAO UESR’s Strategies

6.1 Summary Plan of Reform and Restructuring. Main Stages

Stage I. Initial Restructuring Phase ? Pilot Projects (2003? early 2005)

• launching a transitional wholesale electricity market in a two-stage process:
• Stage 1: a model assuming voluntary participation of consumers (2003 ? 2004),
• Stage 2: a model assuming mandatory participation of consumers (2004),

• launching a small regional market fully on a competitive basis (2004);
• shaping the System Operator’s structure;
• commencement of establishing wholesale GenCos on the basis of RAO UESR’s assets;
• establishing and allocating assets of AO-energos' transmission grids to interregional transmission companies (ITC), optional purchase by OAO FGC UES of the title to the transmission assets (where a source of funds for the purchase has been identified);
• reorganizing pilot AO-energos to the extent of separation by lines of business;
• start of second-order reorganization of AO-energos;
• separation of a number of fully incorporated WGCs based on the thermal generation assets from RAO UES of Russia according to the scheme providing for the exchange of shares in the generation companies for the shares in RAO UES of Russia;
• presumably, separation of OAO FGC UES from RAO UES of Russia by way of reorganization of RAO UES of Russia;
• presumably, separation of some other fully incorporated companies.

 Stage II. Completion of Infrastructural Development and Restructuring of AO Energos (2005?2006)

• setting up a Security Board to ensure efficient coordination of entities participating in the sector’s reform;
• reorganizing all other AO-energos (save some island structures);
• presumably, launch of a fully competitive wholesale market comprising one or several IES ? 2005;
• establishing regional generation companies;
• establishing interregional distribution companies;
• completion of establishing wholesale generation companies (WGCs);
• decision on reorganization of RAO UES of Russia involving establishment of companies not incorporated in the course of the first reorganization. As a result of the reorganization, the following companies will emerge:
• thermal WGCs (which were not separated from RAO UES of Russia according to the arrangement providing for the exchange of shares in the generation companies for the shares in RAO UES of Russia),
• 4 WGCs based on hydroelectric plants,
• a holding of Guarantee Suppliers, isolated AO-energos, non-consolidated RGCs and other non-core and service assets of RAO UES of Russia,
• System Operator (OAO SO-CDU UES),
• about 20 companies each holding shares in one TGC,
• one IDC.

• Government resolution to launch the market (completion of the transitional period).

Stage III. Fully liberalized market (2006?2008)

• Start of operation of liberalized wholesale and retail markets;
• Increasing the government stake in the company operating the Unified National Electricity Grid, in the System Operator, reducing the government stake in wholesale and territorial generation companies.

Thus, by 2008, after the completion of all the principal reform procedures in the holding, each shareholder of RAO UES of Russia who was in a possession of a shareholding prior to the reorganization, and provided that it doesn’t acquire additional shares or disposes of the shares previously held, will hold stakes in the following corporate entities of the industry:

Each shareholder of RAO UES of Russia voting against or abstaining from vote on the issue of the reorganization of RAO UES of Russia (approximately, not later than Q2 2006) and not presenting its shares for redemption in accordance with the established procedure, will receive, about 6 months after the general meeting of RAO UESR shareholders resolves on the reorganization, notices on its ownership of the proportional number of shares in the companies established as a result of the reorganization of RAO UES of Russia.

6.2 Government Control of the Reform

In accordance with the Federal Law "On Electric Power Industry" the Government of the Russian Federation assumes responsibility for decision-making on key aspects of the power sector reform.

The Russian Government Commission for Energy Reform and Expert Council have been set up to review system-wide issues of the sector reform while the Russian Government Commission for Energy Reform has set up a Working Group to study projects of power and electrification companies reform.

Legislative acts of the Russian Federation, Decrees of the President of the Russian Federation, Resolutions of the Russian Federation Government and Commission of the Russian Federation Government on energy sector reform, decisions of the executive federal body concerning the regulation of natural monopolies on the sector reform issues of their competence, after their effective date will be reflected in the Strategy of RAO UES of Russia and will be executed in accordance with the corporate procedures of RAO UES of Russia.

The Security Board involving representatives of the Government, RAO UES of Russia, NP ATS, System Operator, Federal Grid Company, AO-energos and other entities involved in the sector reform is an efficient mechanism for ensuring smooth reform of the power sector. The Security Board will become an efficient instrument for dealing with conflicts of interests which may arise among the increasing number of entities in the market. The Board’s main objective is to ensure efficient coordination of entities participating in the sector reform, to monitor and control the reform process of RAO UESR Holding and to ensure that the government’s interests are taken into account in the process of the power sector reform in the Russian Federation.

The system of controlling the power sector reform at the government level allows coordinating the energy reform with housing and communal services, gas industry, administration and budget reforms and contemplates introduction of:

• clear mechanisms for interaction and coordination of the reform control system with the state property management system;
• mechanisms for minimizing reform-related risks.

6.3 RAO UESR Transformation Control System in the Period of Reform

The transformation control system at the level of RAO UES of Russia ensures consistent methodological support of decisions to be prepared and made by the Government of Russia. With adoption of a legislative package related to the energy, the reform control system will focus on new objectives:

• focus and resource concentration on streamlining corporate and legal patterns of asset transformation and management;
• synchronizing the problem understanding and approaches to solutions of RAO UES of Russia and the Russian Government for further implementation of the reform;
• combining reform processes with current operations;
• reorganizing the management system to ensure the reform of RAO UES of Russia and development of existing and new lines of business.

RAO UES of Russia carries out the processes of design, transformation and operational organization of entities which will compete with each other in the power sector. The reform is managed in the project mode involving appointment of project managers, planning, organization and control of each step of the project’s review by RAO UES of Russia.

Reform projects of entities incorporated in RAO UES of Russia will be approved by the Board of Directors of RAO UES of Russia after they are reviewed by the Committee for reform issues under RAO UESR’s Board of Directors and the Working Group for power sector reform under the Government of Russia. System-wide issues of the reform will be presented to the Committee for reform issues under RAO UES of Russia for consideration.

Renowned international consulting companies will be invited to develop documents of RAO UES of Russia. It is envisaged to involve large investment banks to execute large transactions related to the transfer of RAO UESR’s assets.

It is envisaged to ensure phased transformation in the power sector taking into account the experience to be gained in implementing pilot projects of AO-energos reform.

In order to ensure transparent and equitable appraisal of transactions involving RAO UESR’s assets, it is envisaged to retain appraisal firms accredited with RAO UES of Russia which apply asset appraisal methods developed with the assistance of Deloitte & Touche, a consulting company, including the method of forecasting discounted cash flows after the energy market has been liberalized.

A priority objective for RAO UESR’s management is higher capitalization of the holding company (cost management) for which purpose it is envisaged to develop a methodology for higher efficiency and transparency of entities which make up the holding company.

 Principal Elements of Managing Transformation of RAO UES of Russia:

a. Development and Use of Transparent Corporate Mechanisms in the Process of Restructuring Subsidiary and Associated Companies of RAO UES of Russia.

AO-energos will be divided by business lines with a view to securing the interests of the company’s shareholders, which will be effected on the basis of support of minority shareholders by reorganizing the company into independent businesses with shares of new companies to be proportionally distributed among shareholders of AO-energos.

b. Transition from the Administrative to Corporate Management System Within RAO UES of Russia.

A corporate system of managing subsidiary and associated companies within RAO UES of Russia will enhance independence of the latter in short-term decision making and enable to reduce operational and administrative functions in executive divisions of RAO UES of Russia.

c. Changing the Management System as Regards Delegating Managerial Authorities to Subsidiary and Associated Companies

It is envisaged to delegate authorities to the management level of structural units ensuring the power sector reform and to enhance the authority of deputy chairmen for development and reform functions with regard to strategic and investment decision-making.

d. Managing Transition of RAO UESR’s Current Operations to Market Mechanisms and Methodological Support to Reform of Subsidiary and Associated Companies

In order to improve efficiency of RAO UESR’s current operations and to create conditions for the Company operation in the market environment, it is necessary to build legal market mechanisms into the processes of distribution of all types of fuel (above-limit gas) within the Company by establishing an in-house fuel exchange. Similar principles need to be introduced in the area of organization of repairs, design and research activities.

 7    Ensuring the Transparency of RAO UESR Holding Reform and Protection of Shareholders' Interests

 RAO UES of Russia strives to ensure the transparency of the transformation processes brought about by the restructuring of RAO UESR Holding Company in the following key areas:

1. Equality of rights of all shareholders and fair principles of restructuring in the interests of all shareholders.
2. Ensuring the transparency of the restructuring mechanisms and procedures for the shareholders and interested parties.
3. Establishing a system enabling the shareholders to control the progress of the restructuring and participate in the decision-making process with respect to the issues concerning the protection of their interests and rights.

Restructuring of RAO UESR Holding Company takes the shape of a chain of transformations of the corporate members of RAO UESR Holding and of the parent company proper.

Important feature of Russia's power sector in the current period which puts specific requirements on the whole industry transformation process is the private form of property of all the corporate entities of the Holding Company and substantial numbers of minority shareholders, as well as the presence of the state as a majority shareholder in the holding's parent company.

The restructuring process in the holding will see substantial changes in the structure of property owned by the holding's corporate members emerging as a result of the formation of new companies with new asset structure on the basis of the existing ones as well as the shareholders' participatory interests in the new power facilities.

 Ownership structure.

The eventual structure of the industry – the target of the whole corporate restructuring process undertaken by the Holding Company - is determined by the following key guidelines:

• Tasks and objectives of the sector reform;
• Tasks of the industry set and accomplished by the state through the ownership of specific assets as well as the application of regulatory instruments in pursuing its mid- and long-term economic policy;
• Current legal provisions restricting the range of the mechanisms which can be used in the restructuring process as well as the timeframe of the corporate transformation;
• Legal provisions governing the relations between the players in the power sector and restricting the potential combination of particular types of business by organizationally integrated legal entities and, subsequently, by groups of affiliated entities.

 7.1 Equality of Rights of All Shareholders and Fair Restructuring Principles

Pursuant to the key guidelines stated above, RAO UES of Russia will be shaping the new industry structure and redistributing assets between the companies emerging in the restructuring process on the basis of the following principles:

• Compliance with all the legal requirements placed on the companies with respect to the liberalization of the power market and the ownership structure in the sector

Allocation of assets to the companies is to be based on functional criteria and the type of business conducted by particular entities. Incorporation of new entities and initial allocation of assets thereto shall be effected, wherever possible, subject to the requirements of the law with respect to the target industry structure.

• Compliance with the legal provisions governing the corporate transformation procedures

One absolute requirement which is to be met by all the mechanisms and procedures intended for use and applied in the process of restructuring RAO UESR Holding Company is the requirement of legality, as in letter, so in spirit.

We are stating this in full awareness of the fact that a number of current legislative and regulatory provisions do not allow RAO UES of Russia to carry out the restructuring in the most efficient manner. As well as the imperfection of the particular elements of the legal framework, this is due to the lack of experience in application of specific legal provisions.

• Safeguarding the entitlement to the proportional distribution of shares in the newly established companies in cases where the reorganization decisions are passed by a simple majority of the shareholders' votes

Unbundling with a proportional distribution of shareholdings is the most basic and fair mechanism of the companies separation from RAO UES of Russia. Management of RAO UES of Russia guarantees that each shareholder (whether in RAO UES of Russia or in its subsidiaries and associated companies) is entitled to receive a proportional share in the companies emerging in the restructuring process.

• Setting up economically and financially stable companies

The industry reform process should involve the establishment of economically and financially stable companies. The emerging companies should, wherever possible, enjoy equal financial strength and have enough resources to meet their obligations right from the start. Operations of each established company should be profitable and generate shareholder value.

• Maximum possible aggregation of the newly-established companies, with a view to economic efficiency of the business and its shareholders and avoidance of monopolistic / oligopolistic practices

The size of the new companies is an important parameter for shareholders and partners of the companies. From the investors' perspective, it is essential that the companies created in the course of the restructuring have adequate size in order to ensure:

1. their financial viability;
2. the liquidity of investments (no investor would prefer illiquid shares of a large number of small companies to a single highly liquid share of RAO UES of Russia).

By the same token, partners and consumers prefer to deal with the companies meeting certain minimum criteria of size and therefore capable of ensuring reliable supplies of electricity and meeting their financial obligations in a consistent manner.

Therefore, the companies division by their lines of business is expected to be followed by their horizontal integration. The size of the companies created in this process (in the generation as well as supply business) will be dictated by the statutory requirement of safeguarding free competition and the need to avoid monopolistic / oligopolistic situations and determinative influencing of the prices in a wholesale or a retail market of a specific territory.

The final decisions concerning the aggregation of regional companies into companies integrated at interregional level rest with the shareholders of such companies and have to comply with the requirements of the current law of the Russian Federation, regulations of the RF Government (including those establishing the operational rules of the wholesale and retail electricity markets, lists and configurations of the new wholesale generation companies, as well as other decisions), resolutions of the Board of Directors of RAO UES of Russia and other competent authorities. Companies integrated at the interregional level are expected to be established as wholly-owned subsidiaries of RAO UES of Russia taking stakes in the integrated companies owned by RAO UES of Russia. Later, at the stage of the transition to a single share, such companies will be established through the exchange of the shares in the companies integrated at interregional level for the shares in their parent companies, with subsequent merger or acquisition (subject to the consent of the shareholders of all the participating companies). Under the current Russian Federation law, application of the reorganization procedure (including the merger or acquisition) requires a resolution passed by a qualified majority of votes representing at least three fourths of the owners of the voting stock present at the general meeting of shareholders. Therefore, the consent of the owners of the blocking stakes in the regional companies established as a result of reorganization of АО-energos at the stage of the transition to a single share and during the incorporation of single operating companies integrated at interregional level is indispensable.

Other criteria that are used to determine the number and configuration of the companies include the potential economic effects of their aggregation (economies of scale), the need to retain the opportunities to offer incentives for effective cost-saving (for operations characterized by natural monopoly situation - benchmarking), definition of optimal size of the companies in terms of their economic stability and viability, with the absolute priority being given to establishing strong companies appealing to a wide range of strategic investors and capital market players.

• Transition to a single share wherever possible

Shareholders' interest is to hold shares in large, integrated companies. Long-term tendency of the restructuring, according to the management of RAO UES of Russia, is the transition to a single share in all the newly created companies. Transition to a single share is the most efficient way of improving corporate functionality in terms of increasing the companies' capitalization and driving down the cost of capital (including the cost of borrowed funds) - which, in the final analysis, would mean that the companies are able to cut the consumer tariffs with no adverse effects to their own interests.

We understand that the transition of the transmission companies (FGC and IDC, subject to the transparency of the regulatory environment) to a single share in the mid-term perspective should be relatively easy in terms of the companies' valuation and could, therefore, be completed within a rather short timeframe.

Unlike the transmission assets, with the generation companies this process is going to prove more difficult in the transitional period, due to the current absence of a real and operational electricity market and the resulting uncertainty about the valuation of these assets (as a result of the differences in the characteristics of the generating plants, uncertainties related to the emergence of the electricity market, fluctuations of the fuel prices, etc.).

It is assumed that the transition to a single share may be effected in three ways:

• Merger (acquisition) of companies involving the conversion of shares and establishment of a single operator
• Exchange of the shares in the parent company of the holding for the shares in its subsidiaries
• Redemption of shares in the subsidiaries for cash or against debt liability

Although a number of shareholders quite reasonably prefer a transition to a single share, we understand that in some cases such transition may be precluded by the decisions of the state and the RF Government with respect to certain companies, due to their strategic importance for the country or their role in the system whereby the RF Government controls the progress of the reform at the transitional and the initial post-transition phase. Due to the legally imposed restrictions, at the initial stage the FGC, hydro WGCs and, possibly, IDCs will not effect full transition to a single share.

• Maintaining the amounts and terms of repayment of the liabilities of the reorganized companies to their creditors; fair distribution of accounts payable in the course of the restructuring to avoid any deterioration in the position of the creditors and of particular newly-established companies.

• The transparency and fairness of the assets valuation during their transfers is the main principle of such transactions

Transfers of assets in the course of the corporate reorganization require, according to the provisions of the current law, engagement of independent appraisers providing their opinion on the market value of such assets. All the decisions will be taken with due regard to the results of the independent appraisals and on the basis of the best international practices of corporate asset transfers.

Valuation of the assets and businesses of all types will be based on the valuation methodology currently developed by the internationally reputed company Deloitte & Touche on the request of the Board of Directors of RAO UES of Russia. It is expected that the methodology will be approved by the Board of Directors in 2003. After its approval by the Board of Directors of RAO UES of Russia, the methodology will become an official public document and will be mandatory for use by independent appraisers.

On the other hand, accurate valuation of the generation business - at least, during the transitional period – is going to pose substantial difficulties, until the whole system of the power sector is liberalized and the generation companies operate independently in a market environment. This doesn’t mean, however, that the shareholders can not reach mutually beneficial agreements on transfers of specific generation assets.

Still, provided the regulatory system is adequately transparent, the transmission and distribution assets may prove rather easy to valuate, which is why the most speedy adoption by the RF Government and the RF Federal Energy Commission of a clear regulatory framework and, in particular, an unequivocal position of the regulator with respect to the level of the Regulatory Capital Base (RCB) and the market rate of return calculated on the RCB (MRR) appears to be a priority objective.

• The transparency of asset transfer transactions

RAO UES of Russia seeks to maximize the economic benefit of the asset transfers. To this end, it intends to apply and consistently expand the scope of the competition principle with respect to its counterparties in such transactions through holding auctions, competitive bidding sessions, tenders and other forms of competitive vendor selection.

In this process, the industry restructuring plans will impose further natural restrictions on the terms of selection of the participants and the winner selection criteria.

• Minimization of restructuring costs in the assets-related transactions

RAO UES of Russia seeks to minimize the restructuring costs of all the companies by reducing the transaction costs of the restructuring process. This will involve continuous development of a set of measures, including amendments to the legislative framework governing the restructuring processes and conducting preliminary negotiations with the principal business partners.

• Strengthening the protection of shareholders' rights

In addition to the general principles and measures aimed at the protection of the shareholders' rights, RAO UES of Russia proposes to improve the legislative practice by securing the tag-along right to its shareholders.

Minority shareholders voice concerns about the potential infringement on their interests in the course of the reform. In particular, this may occur in the following cases: (i) the shareholders remain minority shareholders in subsidiaries within a holding structure without an opportunity of transition to a single share on fair terms; and (ii) a major shareholder (owning a controlling or blocking stake) is in a position to sell its shares on more beneficial terms than the minority shareholders. Such a situation is particularly typical of Russia, where the strategic investors may be uninterested in the maximization of value of the power companies, their objective being, for example, to secure supplies of coal or gas to the power plants and/or low price for the electricity they buy.

Therefore, we propose that, in cases where one or several shareholders acquire control over 30 or more per cent of the share capital of the companies established as a result of acquisition of stakes from RAO UES of Russia (or from the state, following the proportional distribution of shares), the state or RAO UES of Russia should provide for each shareholder a right to sell shares at the same price as that quoted by RAO UES of Russia or the state. This right is described as a "tag-along right" and may be safeguarded by legislative provision or in the incorporation instruments of the company. We believe that this procedure will ensure higher valuation of shares in the new companies and a decrease in the cost of capital, which, in turn, will result in gradual lowering of the tariffs.

This provision is safeguarded to a certain extent by Article 80 of the Federal Law "On Joint-Stock Companies", although we propose to expand it to ensure full compliance with the international practices (the benchmark used to determine the price of shares redemption from the minority shareholders is the purchase price applicable to a large stake, rather than the "average market price" over a six-month period). In this way the control premium also becomes available to the minority shareholders.

Compliance with the above principles is a mandatory requirement in the process of the design and implementation of the restructuring of the corporate entities operating in the power sector of the Russian Federation.

7.2 Ensuring the Transparency of the Restructuring Mechanisms and Procedures for the Shareholders and Interested Parties

• Ensuring the transparency of the restructuring procedures:

Ensuring the transparency of the restructuring procedures is one of the key mechanisms for the protection of the shareholders' rights. Key measures ensuring such transparency and the protection of the shareholders' rights are the following:

• Improvement of the corporate governance system and implementation of the best international corporate governance practices
• Full adoption of the corporate methods of management applied to the subsidiaries of RAO UES of Russia
• Translation of the corporate governance practices adopted by the Holding Company to all the entities established in the course of the restructuring, which would involve adoption by the shareholders and the management of the established companies of adequate by-laws.

One of the key parameters of the transparency is the information policy of the companies pursued in the course of the transformation. RAO UESR's management intends to disclose the fullest and clearest possible information concerning all the transactions and important corporate activities to be conducted in the process of restructuring the corporate entities of the holding. The first step towards greater transparency is the adoption by RAO UESR's Board of Directors of the concept of the Company's Strategy describing principal stages and activities of the reform as well as the mechanisms applied in its course, establishing the principles of the intended reform, thereby affording the shareholders a greater degree of certainty. In future the Company intends to periodically update and elaborate its plans for the reform activities.

The Company intends to apply in the course of the reform the best international practices ensuring the transaction transparency. It is important to note that all the decisions of RAO UESR's Board of Directors are accessible to the shareholders and other interested parties and posted on the official corporate website. According to the current decision-making system of the Company, as prescribed by the statutory provision, its Board of Directors is the final decision-making authority with respect to the key issues affecting the shareholders' interests, be it the matters of ideological and methodological nature or any transfers of assets of the Holding's corporate members.

Pursuant to its Corporate Charter and the Corporate Governance Code, RAO UES of Russia has adopted a "Procedure for RAO UESR Interaction with Business Companies of Which Shares (stakes) RAO UESR is a Holder" ("subsidiaries and associated companies", or "SACs"), which is a public document posted on the website of RAO UES of Russia. This Procedure governs the issues relating to exercising by RAO UESR of its rights of a shareholder with respect to its subsidiaries and associated companies, establishes other terms and conditions of corporate relationships and defines any additional matters to be considered by the Board of Directors of RAO UES of Russia, including:

• conclusion of major deals by SACs;
• decisions concerning the SACs participation in other organizations;
• decisions concerning the SACs' transactions (including acquisition, disposal, hypothecation or any other type of encumbrance through execution of a single transaction or a number of related transactions) involving shares or stakes in the SACs' subsidiaries and associated companies engaged in the business of generation, transmission, dispatching, distribution and supply of the electric and heat energy, irrespective of the number of shares/size of stakes in the authorized capital of such companies;

• decisions concerning the SACs' transactions (including acquisition, disposal, hypothecation or any other type of encumbrance through execution of a single transaction or a number of related transactions) involving shares or stakes in the SACs' subsidiaries and associated companies which are not engaged in the business of generation, transmission, dispatching, distribution and supply of the electric and heat energy, where the market value of the shares or stakes the transfer of which is contemplated in the transaction is established by an independent appraiser to be in excess of RUR30M;
• conclusion by the SACs and their subsidiaries and associated companies of transactions involving disposal of property comprising fixed assets, intangible assets or work-in-progress intended for the generation, transmission, dispatching or distribution of the electric and heat energy, with the book value in excess of RUR15M;
• conclusion of transactions involving non-current assets of the SACs in the proportion between 10 and 25 per cent of the book value of such non-current assets of the SACs.

These procedures ensure maximum transparency and involvement of the representatives of the shareholders in adopting the key decisions on such issues in the corporate members of RAO UESR Holding Company in the course of the reform and in execution of any other transactions.

• Use of the services of investment banks, consultants and appraisers

All the transactions involving disposal of assets (including non-core, service and other assets) will only be executed under competitive procedures (tenders, auctions etc.) subject to the provisions of the current law of the Russian Federation.

To ensure the integrity of transactions involving the disposal of assets of RAO UES of Russia, the Company will engage independent well-qualified agents: investment banks and specialized companies accredited with RAO UES of Russia. In addition, for activities affecting the interests of shareholders in several companies (mergers, acquisitions, exchanges of shares etc.) it will retain Russian and international investment banks on a competitive basis. The principal requirements placed on such investment bank are its international repute and a successful record of completion of similar transactions in Russia.

To enhance the quality of the restructuring process and reduce the associated risks, the companies of RAO UES of Russia engage experienced consultants (to obtain advice on management, legal and taxation issues).

Lack of any conflicts of interest will be a mandatory requirement for all the agents and investment banks participating in the restructuring process. Conflict of interest is a participation in the share capital of companies interested in particular decisions which may be influenced by the engaged company, or representation of interests of one of the shareholders who is a party to a transaction relating to other projects.

Any disposals of assets, including shares, requiring valuation of assets or appraisal of a business (in accordance with the current law, internal regulations or international practices) shall involve competitive engagement of independent appraisers accredited with RAO UES of Russia.

Appraisals shall be carried out pursuant to the uniform "Procedure for Appraisal of Energy Companies' Assets and Business in the Course of Reform", currently being developed on the request of the Board of Directors of RAO UES of Russia by Deloitte & Touche CIS. After the approval of the Procedure it will be published and made available to all the interested parties.

Engagement of agents and specialized companies for the execution of transactions shall be effected on a competitive basis, subject to the procedure established by the internal regulations of RAO UES of Russia.

Selection of the appraisers by the corporate members of RAO UESR Holding Company shall be effected on a competitive basis from among the companies accredited with the Appraisal Committee of the Board of Directors of RAO UES of Russia. The competitive selection should involve at least 5 bidders.

7.3 Establishing a System Enabling the Shareholders to Control the Progress of the Restructuring and Participate in the Decision-Making Process with Respect to the Issues Concerning the Protection of Their Interests and Rights

In the recent years the role of the minority shareholders in the corporate members of RAO UES of Russia has substantially increased. Minority shareholders are represented in RAO UESR's Board of Directors as well as the boards of many subsidiaries. The number of independent directors on the boards of directors of the Holding Company subsidiaries is constantly rising. The Board of Directors of RAO UES of Russia has already established a number of committees and working groups which include representatives of the shareholders:

• Standing Appraisal Committee (principal tasks: approval of the procedures governing the selection of appraisers, managing the development of the "Procedure for Appraisal of Energy Companies' Assets and Business in the Course of Reform", accreditation of the appraisers with RAO UES of Russia, consideration and approval of the appraisers' reports in the course of the reform of the corporate members of RAO UES of Russia);
• Reform Committee, considering all the reform projects and programs of RAO UES of Russia and its subsidiaries;
• Working Group of RAO UESR's Board of Directors for the strategy updates;

A number of additional committees of the Board of Directors are planned to be established:

• Audit Committee;
• Compensation Committee.

Companies of the holding also intend to set up personnel committees, to consider and approve candidates to the management positions in all the companies established in the course of the reform. The committees will include representatives of minority shareholders.

It is important to emphasize the significant role played in the system of management of the corporate members of RAO UES of Russia by the boards of directors of the companies, as the corporate management method remains the main method of management of the holding's subsidiaries – all the principal decisions (both in RAO UES of Russia and in the SACs) are adopted by the boards of directors.

Management of RAO UES of Russia believes that the maximum transparency is a key guarantee of successful and conflict-free progress of reform. In the second half of 2002 the management has imposed a "moratorium" on the sales of core assets of RAO UESR Holding Company, effective until the approval of the "Procedure for Appraisal of Energy Companies' Assets and Business in the Course of Reform" by RAO UESR's Board of Directors. To ensure the compliance with this decision, RAO UESR's Board of Directors, on the initiative of the Company's management, decided to prepare a list of core assets of RAO UES of Russia which are not subject to sale. The list of such assets approved by a resolution of RAO UESR's Board of Directors includes transmission assets owned by OAO FGC UES as well as the assets intended for incorporation in the wholesale generation companies (subject to possible changes in accordance with the decision of the RF Government concerning the list and configuration of the established generation companies of the wholesale market).

Improvement of the information policy, enhancement of the role of the corporate methods of governance and participation of the representatives of minority shareholders in the adoption of key decisions are absolute priorities for the management of RAO UES of Russia, its subsidiaries and associated companies.

1. Territorial generation companies created on the basis of assets of the RAO UESR Holding
2. Generation companies of the Wholesale power market

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