1. 0 REGULATION OF TARIFFS WITH USE OF THE METHOD OF RETURN ON THE INVESTED CAPITAL July 27, 2007 Moscow Aleksey Makrushin, FGC

2. 1 PRINCIPLES OF THE METHOD OF RETURN ON THE INVESTED CAPITAL AIM: Building and modernisation of the grid infrastructure that provides accessible, reliable and high-quality supply of consumers with electric energy and connection to the networks of new consumers and objects of generation MEANS: Attraction to the branch of long-term investments, decrease of investment risks and cost of the invested capital Creation of business struggle between local monopolists, stimulation of the companies to striving for efficiency of operating and investment expenses ESSENTIAL CONDITION: The consumer must not suffer during turn of DGC to use of the method of return on the invested capital

3. 2 TARIFF DESIGN IN RAB SYSTEM

4. 3 REGULATED BASE OF THE INVESTED CAPITAL Base of the capital for the beginning of the year Investments Repatriation of the capital Original amount of capital is fixed as equal to the cost of substitution of the fixed assets, intangible assets, and incomplete construction with regard of depreciation Objects built in accordance with the coordinated investment program Repatriation of the capital is carried out during economically sound equipment service life

5. 4 RATE OF RETURN ON THE INVESTED CAPITAL Nominal rate, before payment of taxes Economically achievable optimal leverage Base of the invested capital is corrected with account of swing of risk-free interest rate (for example, at change of forecast of inflation and exchange-value of ruble) 7–8% cost of capital of federal monopolies 1–2% regional risks 3–4% Return on government papers Borrowed capital 11–13% remuneration for branch risks and size of the company Joint-stock capital 8–10%14-16% 12–14%

6. 5 RISK DISCOUNT MECHANISM Inflation Price risks Swing of return on the invested capital Europe Inflation Price risks Russia Rate of return Indexation Core Inflation Nominal Change of return on T-bills (takes into account all risks)

7. 6 HOW TO GAIN OPERATIONAL FAT? Private owner creates PRESSING on management to decrease expenses in order to make profit from growth of capitalisation The state creates regulatory enviroment controlling reliability and stimulating dicrease of expenses Logic of state ownership and management of DGC in expenses+ system Logic of private ownership and management of DGC in RAB-Regulation system The state cannot effectively combat growth of tariffs without detriment to reliability The state controls not the result (reliability and capitalisation) but the process itself – realisation of expenses The system is built up on opposition of DGC and the regulator regulator management Expenses Reliability Expenses Reliability Driving force of effectiveness –desire of the private investor to make profit from growth of capitalisation by disposal of operational fat

8. 7 RESERVES OF CUT-DOWN ON OPERATING EXPENSES Benchmark study of lossLines, km / staff, people Loss rate Rate of low pressure in productive supply 3% 6% 9% 12% 15% 18% 0%20%40%60% Russian distribution networks East European distribution networks West European distribution networks 13 8 14 13 7 11 13 20 10 15 65 0 10 20 30 40 50 60 70 Moscow St.Petersburg Rostov Nizhni Novgorod Ekaterinburg Chelyabinsk Volgograd Pskov Vladimir Tula CE East EON

9. 8 REGULATION OF OPERATING EXPENSES ACCORDING TO PRICE CAP SYSTEM Costs included into the tariff Material costs In the new period of regulation reasonableness of expenses of the previous period is taken into account In the new period expenses are fixed on the basis of the actually achieved level

10. 9 MECHANISM OF MAINTENANCE OF ECONOMIES BY WAY OF REDUCTION OF EXPENSES Economies of the previous years Economies of the current year Expenses Profit from economy of consumption Economies that were not, specified in the first period Unspecified economies are averaged out Tariff with consideration for economies of the previous period The profit lasts 5 years

11. 10 LONG-TERM CONSEQUENSES OF SWITCH TO RAB SYSTEM Long-run objectives of switch to RAB System Provision of economic growth due to development and modernisation of network infrastructure  Attraction of massive private investments Decrease of expenses of consumers  economical incentives to decrease expenses  Decrease of cost of the capital Increase of reliability and quality of service on transmission of e/e  Conformity of tariffs with the level of reliability and quality of services Growth of capitalisation  Increase of base of the invested capital due to growth of investments  Decrease of regulatory risks and uncertainty

12. 11 STRUCTURE OF THE TARIFFE ON TRANSMISSION OF E/E IN RUSSIA AND GREAT BRITAIN Grid companies of the Russian Federation Grid companies of Great Britain Data of business plans for 2006Reports of the companies for 2004 0% 20% 40% 60% 80% 100% Moscow St.Petersburg Rostov Nizhni Novgorod Ekateringburg Chelyabinsk Volgograd Pskov Vladimir Tula FGC Investment part Operating part 0% 20% 40% 60% 80% 100% Red Electrica Endesa National Grid Reseau d'E TenneT ENEL Elia Svenska Kraftnat FINGRID Investment part Operating part

13. 12 RESULTS OF THE REFORM OF TARIFF REGULATION IN GREAT BRITAIN Source: OFGEM, proper calculations £M

14. 13 TARIFFS ON ELECTRIC ENERGY IN THE PERIOD OF REFORMING OF THE ENERGY INDUSTRY The government fixes maximum levels of prices on electric energy for consumers with different prices for the population Since January 1, 2011electric energy is in the full amount transferred at free (not regulated) prices (except for the population) The population will be supplied with electric energy at free prices not earlier than in 2014 Activity on transfer of electric energy has to be regulated and controlled by the government (including state regulation of tariffs). Constituent entities of the Russian Federation have the powers to fix the tariffs Stake of electric energy realised on the wholesale market at regulated prices The government fixes maximum amount of electric energy for sale at free and regulated prices on the wholesale market and price zones of the wholesale market Forming of tariffs on electric energy in the transition period (until 2011) Sources: 35-FZ On Electric Power Industry, 36-ФЗ On Peculiarities of Functioning of Electric Power Industry in The Transition Period, 147-FZ On Natural Monopolies, Government decree №643 On The Rules of The Wholesale Market of Electric Energy (capacity) of The Transition Period

15. 14 SWITCH TO RAB SYSTEM UNDER CONDITIONS OF MAXIMUMS TARIFFS Forming of discountCalculation of tariff with view of discount The discount allows to switch to RAB system with maintenance of level of the tariff growth in the existing system of regulation The discount is maximum in systems with low capital outlays and undervalued fixed assets The amount of discount equals 30 – 40 % from the return and repatriation of the capital (15 – 20% of the necessary gross proceeds) Abandoning the discount in pilot systems can be performed within 3 years During the period of validity of the discount payment for technical connection is preserved

16. 15 STEPS OF THE GOVERNMENT IN REFORMING OF THE SYSTEM OF TARIFF REGULATION October 19, 2006, order of President: “To introduce proposals on changing of tariff policy that guarantee attraction of investments into development of transmission and distribution electric networks” November 30, 2006, order of President: “… until June 1, 2007 to complete the methods of tariff regulation of services on electric energy transmission aimed at stimulation of development of network infrastructure on the basis of turn on January 1,2008 to establishment of long-term tariffs with regard of guarantee of effectiveness of investments and stimulation of network companies to decrease of their expenses…” December 29, 2006, resolution of Interagency Committee on Reforming of Electric Power Industry (Khristenko’s committee). “… to prepare amendments to the existing legislation of the Russian Federation, aiming at installation in distribution grid companies of system of tariff regulation based on principles of fair market return of the capital employed (RAB) together with economic incentives for a large-scale attraction of private investments…”

17. 16 CHANGES IN 35-FZ ON ELECTRIC POWER INDUSTRY Opportunity of setting preliminary tariffs, including maximum ones, is stipulated The government of the Russian Federation and the ministries have the powers to establish long-term parametres of regulation (rate of return, х-factor) Maximum tariffs may be exceeded without coordination with Federal Tariff Service if it is caused by necessity of realisation of investments The norm is introduced that guarantees not only return on the capital at the level of other branches but also repatriation of the invested and borrowed capital The proprietor can Собственник may lose his/her right to manage networks if he/she misuses them

18. 17 AMENDMENT TO GOVERNMENT DECREE №109 Item 35 concerning methods of return on the invested capital is completed. The said RAB method can be used in the whole electric power industry –Necessary gross proceeds were formed from operating expenses, returns on the invested capital and repatriation of the invested capital –Principles of calculation of the investment capital base were fixed –Powers to establish rates on returns were transferred to the Ministry for Economic Development and Trade of the Russian Federation –Expenses included into NGP on the basis of indexation (controllable) and in factual volume (uncontrollable) were fixed –Rules of the annual updating of NGP were fixed Main features of use of RAB in distribution networks was formulated in item 65 –The period of capital repatriation equals 20 years –During transition period (2008-2010) х-factor equals 0, remuneration/penalties for achievement of indicators of reliability and quality of services on transmission of electric energy were restricted –Possibility of discount on the invested capital base with full change of discount within 3 years and repayment of withheld returns until 2015 were stipulated Item 7 – Establishes attachment of tariff to reliability and quality of services Item 8 – Stipulates incentives to decrease of expenses – maintenance of economies resulted from decrease of expenses during 5 years

19. 18 THE CURRENT STATE OF THE REFORM OF TARIFF REGULATION On May 18 and July 4 JSC UES FGC (А.А. Demin, А.N. Rappoport) sent to the Federal Tariff Service of Russia a proposal on reforming of the system of tariff design including normative legal documents providing switch to RAB system On May 24 Minpromenergo of Russia (А.V. Dementiev) sent to the Federal Tariff Service of Russia proposal on development of methods of tariff regulation of services on transmission of electric energy based on the principles of RAB system On May 25 the Federal Tariff Service of Russia (Ye.V. Yarkin) sent to the Ministry for Economic Development and Trade of Russia, the Ministry of Industry and Energy of Russia and the Federal Antimonopoly Service of Russia draft addendum to Methodical guidelines on calculation of regulated tariffs and prices on electric (thermal) energy on the retail (consumer’s) market Proposals of the Federal Tariff Service of Russiaне were coordinated with the Ministry for Economic Development and Trade of Russia, the Ministry of Industry and Energy of Russia and the FAS of Russia On June 2 the Adimistration of President of the Russian Federation (S.S. Sobyanin) sent a letter to the government of the Russian Federtion ordering to prepare by August 01 a report on the progress of realisation of the orders of President of the Russian Federation On June 15 the Federal Tariff Service f Russia (Ye.V. Yarkin) sent a letter to Minpromenergo og Russia with the report on realisation of the order of the government of the Russian Federation and a request to postpone the date of completion of the given order On July 18 Minpromenergo of Russiaи (V.B. Khristenko) sent to the government of the Russian Federation a letter and the report on the progress of realisation of the orders of President of the Russian Federation

20. 19 CHART OF SWITCH TO RAB SYSTEM 2007 Development of normative legal base Federal law 35 –FZ On Electric Power Industry Government Decree 109 on Price Formation Concerning Electric an Thermal Energy Federal law 41-FZ On State Regulation of Tariffs on Electric and Thermal Energy Methodical guidelines of the Federal Tariff Service of Russia on calculation of tariffs with Use of method of returns on the invested capital Methodical guidelines Concerning calculationof rate of returns On the invested capital Selection of pilot DGC 2008 2009 2010 2011 Forming of IDGC MUPGC,MCGC,Sverdlovenergo,Permenergo, Volga DGC, Orenburgenergo, Nizhnovenergo,,,, Belgorodenergo,Kubanenergo, Krasnoyarskenergo, Kuzbassenergo, Switch of IDGC to RAB in the majority of constituent entities of the Russian Federation Switch to RAB of pilot DGC Switch of IDGC to RAB in all constituent entities of The Russian Federation Targeted structure of RAB Regulation period – 5 years5 Abandoning of discount Establishment of a normative tempo Of growth of operating expenses (of x-factor)- Establishment of tariffs with account Of reliability and quality of services On transfer of e/e/э Structural decision on practice of Payment for technical connection Establishment of parameters of RAB for2008–2010 Calculation of tariffs by RAB method Usage of system of assessment Of reliability and quality of services on Transfer of e/e in test mode/ Gradual increase of the amount of discount Completion of development Of normative legal base Establishment of the original Base of the invested capital Establishment of discount on expenses On provision of returns and repatriation Of the invested capital Establishment of rate of returns On the invested capital Establishment of normative tempo Of decrease of expenses (x-factor)(х-) Methods of reliability observation and Quality of services on transfer of e/e/э Methods of account of normative tempo Of decrease of operating expenses (Of х- factor)- Methods of calculation of the original base Of the invested capital Establishment of the level of operating Expenses and indexation of operating Expenses on the rate of price increases Of producers and salary Abandoning of maximum tariffs Establishment of parameters of RAB for2011–2015