Key Risk Factors

The performance of the Company’s SDCs may be affected by risks that should be taken into account by stakeholders. The key risk factors described below are currently considered by the Company to be the most important.

Country and Regional Risks

Country and regional risks are determined primarily by macroeconomic factors existing globally, nationwide, and at a regional level. These factors may prevent the Company and SDCs from borrowing, thus adversely impacting their liquidity, investment and operating efficiency, and, eventually, shareholder value. Additionally, the global economic crisis has a harmful effect on industrial production and electricity consumption, which reduces revenues of the Company and SDCs.

The primary factors of macroeconomic risks are the continuing global financial crisis affecting the key indicators of commodity and financial markets: prices of crude oil and other commodities, the cost of capital, world currency exchange rates, and inflation. As is the case with the other BRICS countries, Russia is a leading emerging economy and is sensitive to global recessionary pressures. This is due to the economy’s dependence on energy prices, the immaturity and volatility of the Russian financial market, and the transitional state of the national banking system.

Inflation Risks

The adverse impacts of inflation on financial and economic activities of SDCs and the Company can be connected with loss of the actual value of receivables, an increase in loan interest, and higher construction costs related to the capital investment program’s facilities. The current inflation rate does not have a material effect on the Company’s financial condition. In accordance with the plans of the Bank of Russia to curb inflation and the inflation forecasts for the near future, it is unlikely that inflation will substantially affect the financial results of SDCs and the Company.

Currency Risks

An adverse change in foreign exchange rates may affect the indicators of the operating and investment efficiency of the Company and its SDCs.

Currency risks do not have substantial impacts on the Company and its SDCs because settlements with counterparties are entirely denominated in the currency of the Russian Federation. Nevertheless, given that the goods and equipment bought by the Company contain imported components, a considerable increase in foreign exchange rates may lead to higher prices of purchased products. In this connection, the Company is pursuing a policy aimed at import substitution and entering into long-term contracts that do not specify any increase in prices of purchased products.

Interest Rate Risks

Changes in the refinancing rate of the Bank of Russia reflect the macroeconomic situation and affects borrowing costs. A rise in loan interest rates may result in an unplanned increase in debt service expenses incurred by the Company and SDCs. To reduce the interest rate risk, the Company pursues a balanced borrowing policy aiming to streamline the loan portfolio structure and minimize debt service expenses.

Regulatory (Industry) Risks

The core activities of the Company’s SDCs (the provision of electricity distribution and network connection services) are subject to regulation by the government.

Electricity Tariff Regulation

The tariff regulation policy is aimed at keeping down electricity tariffs, which may lead to limiting the tariff-based sources of financing for the SDCs’ investing and operating activities.

To minimize these risk factors, the Company and SDCs are pursuing a balanced policy on improving the efficiency of investing and operating activities, aimed at reducing costs and optimally planning the structure of the financing sources.

Network Connection Tariff Regulation

Another regulatory risk incurred by the Company is the risk of a decrease in the demand for network connection and electricity distribution services as compared with the planned volume used by regulators to make tariff and balancing decisions. In order to reduce this threat, the Company is continuing work on the monitoring network connection requests and, on the basis of monitoring, on predicting the net delivery of electricity, the demand for network connection services for the following year. It is also continuing work on monitoring the increase in applications submitted to regulatory authorities to set network connection fees for individual projects. At the same time, due to a great number of network connection requests, the Company is not always able to fully satisfy them, which may adversely affect revenues because of the loss of potential customers and lead to a violation of antimonopoly laws concerning electricity distribution and network connection services. To deal with this issue, the Company is improving the business process of processing customers’ network connection requests. Simultaneously, the Company explains to customers the process of providing network connection services, including by publishing information on the provision of services and setting up customer service centers.

Retail Market Regulation

One of the regulatory risks factors is imperfect operation mechanisms of the retail electricity market, which entails disagreements between electric grid companies and retail companies over the volume of consumed electricity and capacity used in tariff calculations. This leads to contested and overdue receivables related to electricity distribution services provided by SDCs, impairing the liquidity and financial stability of the Company’s SDCs.

The total receivables of all of the Company’s SDCs in 2012 increased by 37% to 71 billion rubles. Overdue receivables totaled 39.1 billion rubles at the end of the year and grew by 61% on the previous year.

The Company and SDCs are taking measures to eliminate the causes of disagreements with customers, reduce contested and overdue receivables for services provided, to cooperate with federal government bodies in preparing amendments to the rules for the operation of the retail market, form judicial practice, and set positive precedents. In addition, the Company’s SDCs are implementing Long-Term Development Programs for Electricity Metering Systems in the Retail Electricity Market in Distribution Grids of the Company’s SDCs. These programs have been approved by SDCs’ boards of directors.

Electricity Retail Regulation

Due to the enactment of regulatory documents in late 2012 to simplify the procedure for depriving retail companies of the supplier of last resort status, some of the Company’s SDCs are incurring the risks associated with the necessity of assuming the powers and duties of suppliers of last resort that are lost by retail companies. These risks are as follows:

• risks associated with a rise in the number of receivables of ultimate customers and the writing-off of accumulated receivables under electricity distribution services agreements between retail companies and distribution grid companies
• risks associated with the performance of supplier of last resort functions in the wholesale electricity and capacity market
• risks related to an increase in SDCs’ expenses related to performance of the supplier of last resort functions in excess of the minimum regulated revenue used for calculating retail markups;
• organizational risks associated with the loss of competencies and customer databases and with erroneous payments for consumed electricity

With a view to minimizing these risks, the Company and SDCs are taking measures to cooperate with federal and regional government bodies, the mass media, infrastructure organizations of the wholesale electricity market, law enforcement agencies, and organizations deprived of supplier of last resort status in the performance of supplier of last resort functions and settlement of debts. Additionally, the Company is formulating legislative initiatives to streamline the procedure for changing the supplier of last resort.

Contractual Relationship Regulation

A substantial risk factor is also the cross-subsidy mechanism at the expense of large industrial customers in favor of other customer categories, including households. Several large industrial customers that are directly connected to networks of the Unified National (All-Russian) Electric Grid (UNEG) pay for SDCs’ electricity distribution services at electricity distribution tariffs if, under the last mile agreements between the Company’s SDCs and FGC UES, the electric grid facilities are leased to the Company’s SDCs. In 2010–2013, court rulings ultimately became rather inconsistent in relation to last mile agreements, which allowed some large industrial customers to switch in 2010–2013 to direct agreements with FGC UES by recourse to court action. As estimated by the Company, the termination of the last mile agreements decreased SDCs’ revenues by 12.7 billion rubles in 2012 and may result in lost income of 9.3 billion rubles in 2013.

Total cross-subsidies of all MRSK Holding SDCs in 2012 reached at least 200 billion rubles, which is due to the regional government policy aimed at keeping down tariffs for certain customer groups (households, agricultural and state-financed customers, etc.).

The Ministry of Energy of the Russian Federation issued Order No. 403 of August 24, 2012, whereby the Company’s SDCs and FGC UES entered into lease agreements for UNEG facilities (last mile agreements) for 2013. Electricity distribution using specific UNEG facilities leased by the Company under the last mile agreements is included by federal and regional regulators in the planned volume of electricity distribution services for 2013. In 2012, the President and the Government of the Russian Federation emphasized the importance of tackling the problem of cross-subsidies in the electric power industry. The Ministry of Energy of the Russian Federation was instructed to work out mechanisms for eliminating cross-subsidy practices. The Company plans to take an active part in discussing this problem at the level of federal government bodies.

Investment Regulation

The transition of SDCs to regulation based on the return on invested capital method (Regulatory Asset Base, RAB) involves several risks. The most important of them are as follows:

• losses may be incurred due to an unreliably predicted breakdown of electricity distribution by voltage and the overestimated volume of declared capacity as compared with actual capacity used for making tariff and balancing decisions
• some income may be lost due to putting it aside in implementing the income-equalizing mechanism: in planning the calculation of RAB-based tariffs, regulators are entitled to redistribute an organization’s minimum regulated revenue among years within one long-term period at more than 12% of the base value of such minimum regulated revenue

In order to mitigate these risks, SDCs enter into agreements with regional regulators to define the amount of and sources of finance for their investment activities under long-term regional development programs. This work aims to eliminate any subjectivity in making tariff and balancing decisions by formulating and carrying out the cost management program, including as part of implementation of the Russian President’s instructions to attain an at least 10% annual reduction of per-unit purchase costs related to goods (work, services) within three years in real terms in 2010 prices. In addition, the Company plans to develop and implement regulatory contracts enabling tariffs to be set subject to the quality of the services provided. These contracts should also provide for reciprocal obligations, on the one hand, of grid companies for the quality of services provided (as clearly specified in the contract) and, on the other hand, of regulatory authorities for adjustments to tariff decisions during the long-term period of regulation.

Compliance Risk

Frequent changes in the laws of the Russian Federation under conditions where the industry is subject to government regulation, together with a wide range of regulatory requirements and restrictions, are sources of the risk associated with the failure by the Company and SDCs to comply with laws and other legal regulations, or the requirements established by regulators and supervisors and set forth in internal documents of the Company and its SDCs that determine internal policies, rules, and procedures. (compliance risk).

Activities of the Company and SDCs are governed and overseen by Russian authorities and agencies, such as the Federal Antimonopoly Service, Federal Tariff Service, Federal Financial Markets Service, Federal Taxation Service, Ministry of Energy, Federal Service for Fiscal Monitoring of the Russian Federation, and the Accounts Chamber. Furthermore, as government-linked companies, the Company and SDCs carry out instructions issued by the Russian President and Government. In this connection, the compliance risk factors are of special significance.

As natural monopoly entities, the Company’s SDCs are exposed to the risks involved in their being held to be in violation of antimonopoly laws as related to their provision of network connection services, disclosure of information concerning their services, and procurement operations. In order to reduce this risk, SDCs monitor how promptly customers’ requests and appeals are handled, clearly regulate and monitor the disclosures required under Russian laws.

The Federal Financial Markets Service governs and supervises the activities of the Company and SDCs as related to complying with Russian securities laws, including the disclosure of material facts that can substantially affect the value of securities, and combating insider information misuse.

As provided for in law, the Accounts Chamber is responsible for organizing and overseeing the timely implementation of the federal budget and establishing whether federal budget funds are spent and federal property is used efficiently and reasonably.

Amendments to tax law that involve raised tax rates or changed tax assessment procedures may impair the profitability of the Company and SDCs and increase their tax burden.

SDCs possess, have the leasehold of or have the perpetual right to use most plots of land where their distribution assets are located. Nevertheless, some of the plots lack the registration required under law. In addition, laws specify that the deadline for reregistering the perpetual right to use into ownership or leasehold is January 1, 2015. In order to mitigate this factor, SDCs are in the process of carrying out a program to obtain the reregistration of the perpetual right to use.

With the aim of minimizing the above-mentioned risk factors, the Company and its SDCs are taking measures to improve compliance control. In 2012, the Board of Directors of the Company approved local documents designed to enhance the efficiency and transparency of financial and economic activities of the Company and SDCs and combat corruption. MRSK Holding monitors changes in current laws that affect various aspects of financial and economic activities of the Company and SDCs.

Operational Risks

The Company’s SDCs are taking an active part in investment aimed at renewing and expanding the grid infrastructure, which brings about risks associated with decreasing efficiency and value of investments over the course of implementing investment, innovative development, and R&D programs.

The increasing scope of SDCs’ investment programs makes it necessary to mobilize both internal and borrowed considerable financial resources conforming to the RAB regulation parameters, which is an investment risk factor. Additionally, some SDCs carry out socially important investment projects that are often unprofitable.

Even if financial resources are sufficient for investment program implementation, there is some likelihood of failure to spend investment-related funds on schedule and of the delayed commissioning of facilities covered by SDCs’ investment programs, including due to nonperformance or delayed performance by our contractors and suppliers of their obligations.

In order to mitigate the investment risk, the Company and SDCs:

• plan their capital investment programs taking account of the following efficiency criteria:
  • raising the affordability of the grid infrastructure,
  • reducing the physical deterioration of electric grid facilities and modernizing them
  • achieving a high utilization rate of commissioned facilities
  • linking investment projects to territorial and regional development plans
• monitor the implementation of SDCs’ investment programs and their financing and analyze the reasons behind any deviations of the actual results of investment program implementation from the plans
• adopt investment project management procedures, which include investment project risk management
• take measures to improve the quality of project implementation, raise the effectiveness of investments in the existing grid, cut specific construction costs, and achieve high utilization rates of new facilities
• develop and implement a benchmarking system for specific costs of construction and installation and materials
• build an innovation management system
• automate the investment management systems.

Technological Risks

Technological risks affecting power supply reliability are associated primarily with the high physical deterioration and obsolescence of electric grid assets, failure to conform to operation conditions and operation modes of electric grid equipment, and failure to implement the required repair program. In addition, operational and technological risks may materialize because of the following factors:

• natural and man-made emergencies
• a less efficient management system of assets of SDCs (changed priorities in ensuring the reliability of network operation, incorrect ranking of facilities that should be repaired)
• fallback operation with forced permissible emergency electricity flow
• factors related to equipment operation, including extreme deviations from regulatory and technical requirements, errors made by operating personnel, and failure to comply with dispatching schedules and discipline

If these risks materialize, this may have material economic and reputational consequences. In addition, these risk factors affect the volume of electricity network losses, increasing expenses incurred by SDCs in relation to the purchase of electricity to compensate for losses.

In order to reduce the probability that operational and technological risks occur, the Company and SDCs are taking measures to make the power supply more reliable and prevent process failure risks, including:

• clearing and expanding the pathways of 0.4–220 kV overhead lines
• rehabilitating electric grid facilities;
• expanding the stock of reserve power supply equipment and the stock of vehicles and special equipment for accident recovery work
• carrying out the comprehensive program to modernize (renew) electric grid assets
• modernizing switching equipment and telemetry systems
• improving information collection and transmission systems, process failure analysis systems, systems for forecasting the consequences of process failures, including the implementation of the Automated Management System for Resources for Accident Recovery Work (AMSRARW)
• improving the management system for the emergency reserve necessary for the performance of accident recovery work
• increasing the number of mobile accident recovery crews and improving the quality of their personnel
• carrying out a program to reduce injury risks of electric grid facilities;
• ensuring the training, control, and certification of personnel operating process equipment
• carrying out the insurance program
• implementing the energy conservation and energy efficiency enhancement program

Additionally, with the purpose of mitigating operational and technological risks, the Board of Directors of the Company resolved (Minutes of the Meeting No. 64 of October 7, 2011) to approve the Regulations for the Uniform Technical Policy of MRSK Holding in the Distribution Grid Sector. Furthermore, SDCs are in the process of implementing the production asset administration system based on the actual condition index for equipment.

Environmental Risks

Activities of the Company’s SDCs cover a wide geography, SDCs operating in areas with different climates. There is likelihood of emergencies caused by natural disasters (hurricanes, heavy and freezing rain, freshets and floods, snowdrifts, etc.), which may result in system-wide failures of the operability and performance of electric grid equipment and in power outages suffered by customers of the Company’s SDCs.