1

REGULATION OF TARIFFS WITH USE OF THE METHOD OF RETURN ON THE INVESTED CAPITAL

July 27, 2007

Moscow

Aleksey Makrushin, FGC

2

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

TARIFF DESIGN IN RAB SYSTEM

Operating expenses

Repatriation of the invested

capital

Return on the invested

capital Controllable

operating expenses (intramural maintenance

expenses )

Independent operating expenses(payment of FGC for DGC, services of controlled Organisations, etc.)

New investments

Original baseof

the invested capital

Annual indexation on change of prices

and production output

Necessary gross proceeds

Regulatory tempo of curtailing of expenses

(х-factor)

Repatriation of capital in 20 years

Fixed for a long-term period

Nominal rate of return

Return on the joint-stock capital

Return on the borrowed capital

Leverage

Regulated base Of the capital

Fixed on the ground of independent evaluation of physical value of the fixed assets,

intangible assets and incomplete construction with regard of depreciation

Fixed assets introduced in accordance with, the coordinated investment program

Fixed on the basis of the forecast, updated, annually on deviation of fact

from the plan

Current capital

4

REGULATED BASE OF THE INVESTED CAPITAL

Base of the capital for the beginning of the year

Investments

Repatriation of the capital

Original amount of capitalis 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

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

RISK DISCOUNT MECHANISM

Inflation

Price risks

Swing of return

on the investedcapital

Europe

Inflation

Price risks

Russia

Rate of return

Indexation

Core Inflation

Nominal

Change of return

on T-bills (takes into account

all risks)

7

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

Expense

s

Relia

bili

ty

Expense

s

Relia

bili

ty

Driving force of effectiveness –desire of the private investor to make profit from growth of capitalisation by disposal of operational

fat

8

RESERVES OF CUT-DOWN ONOPERATING EXPENSES

Benchmark study of loss Lines, 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

138

14 137

11 1320

1015

65

0

10

20

30

40

50

60

70

Mosc

ow

St.

Pete

rsbu

rg

Rost

ov

Niz

hni N

ovgoro

d

E

kate

rin

burg

Chely

abin

sk

Volg

og

rad

Psk

ov

Vla

dim

ir

Tula

CE E

ast

EO

N

9

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

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 economiesare averaged out

Tariff with consideration for economies of the previous period

The profit lasts 5 years

11

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

Operating expenses

Amortisation

Returns

Operating expenses

Repatriation of the capital

Return on the capital

ownership capital

Ownership capital

Base of the capital

Debt

loansloans

Debt

Balance cost

Tariffs (in comparable prices )

Investments

Expenses plus

Expenses plus

RAB

RAB

RAB

Expenses plus

Capital

Return decreases Due to decrease of risks

Repatriation of the capital Increases together with growth of the base of the capital

Decrease of expenses is realised due to Growth of investments and economical incentives

Massive investments on new construction

and modernisation of networks

RAB allows to attract

more loans

The base of the capital increases Due to putting in operation of

New equipment and modernisation( decrease of depreciation) of the existing one

(

Gearing is growing (cost of capital isfalling down)

12

STRUCTURE OF THE TARIFFE ON TRANSMISSION OF E/E IN RUSSIA AND GREAT BRITAIN

Grid companies of the Russian Federation

Grid companies of the Russian Federation Grid companies of Great BritainGrid companies of Great Britain

Data of business plans for 2006 Reports of the companies for 2004

0%

20%

40%

60%

80%

100%

M

osc

ow

St.

Pete

rsbu

rg

R

ost

ov

Niz

hni N

ovg

oro

d

Eka

teri

ng

bu

rg

Chely

abin

sk

V

olg

ogra

d

Psk

ov

V

ladim

ir

Tu

la

FG

C

Investment part

Operating part

0%

20%

40%

60%

80%

100%

Red E

lect

rica

Endesa

Nati

onal G

rid

Rese

au d

'E

Ten

neT

EN

EL

Elia

Svensk

a K

raft

nat

FIN

GR

ID

Investment part

Operating part

13

RESULTS OF THE REFORM OF TARIFF REGULATION IN GREAT BRITAIN

Source: OFGEM, proper calculations

£M

600

700

800

900

1 000

1 100

1 200

1 300

1 400

1990 1992 1994 1996 1998 2000 2002 2004

0%

20%

40%

60%

80%

100%

120%

Annual investments Tariff on transmission in real prices

14

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

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

01s .

20072s .

20071s .

20082s .

20081s .

20092s .

20091s .

20102s .

20102s .

20061 s

2006year

Minimal stake of electric energy

realised at regulated prices

Maximum stake of electric energy

realised at regulated по prices

15

SWITCH TO RAB SYSTEMUNDER CONDITIONS OF MAXIMUMS TARIFFS

Forming of discount Calculation 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

Operatingexpenses

Amortisation

Returns

Operatingexpenses

Repatriationof the capital

Return on the capital

Expenses plus

RAB

The amount of dividendsis restricted, the returns

are reinvestedcompulsorily

Cost of the fixed assetsIs marked down 2-5 times ,reevaluation

is annually carried out

Operating expensesin the tariff are lower

than the actual expenses, but the companies

have no incentives to decrease them

Actual cost of the capital

Return in other branches

Operatingexpenses

Repatriationpf the capital

Returns on the capital

RAB with discount

Discount

The capital base decreases slower

Withheld returns are considered in the tariff after

abolishment of discount

Maximumtariff

Tariff

Discount

Repatriation of withheld returns

2008 2009 2010 2011 2012 2013 2014 2015

Tariff

Rate of operating expenses falls away in the tariff

Repatriation of the capital is performed with the fixed tempoSince 2011

Withheld returns are to berepatriated until 2016

Returns on capitalare considered in the tariff in full since 2011

16

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

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

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

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

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 onElectric 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 IDGCMUPGC, 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 FederationSwitch to RAB of pilot DGC

Switch of IDGC to RAB in allconstituent entities of The Russian Federation

Targeted structure of RAB

Regulation period – 5 years 5

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 ofPayment for technical connection

Establishment of parameters ofRAB for 2008 – 2010

Calculation of tariffs by RAB method

Usage of system of assessment Of reliability and quality of services onTransfer of e/e in test mode/

Gradual increase of the amount ofdiscount

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 repatriationOf 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 operatingExpenses on the rate of price increasesOf producers and salary

Abandoning of maximum tariffs

Establishment of parameters of RAB for 2011 – 2015