Annual Report 2013

Key Risks

INDUSTRY RISKS

IDGC of Centre relates the deteriorating situation in the industry to:

  1. Operating (technological) risks

    Operating (technological) risks posed by the insufficient funding for repairs and maintenance and a shortage of investment funds, by the wear and tear of the grid, wrongful usage of the grid equipment, abnormal operating conditions and accidents, which may result in breakdowns (failures) of the grid equipment and irreparable damage to the installations and buildings.

    Poor condition of the equipment caused by physical deterioration and obsolescence is one of the major operating risk factors, which generally include:

    • Poor quality of power transmission services;
    • Equipment failures leading to minor or desperate energy shortage with the adverse social, environmental and economic impact.

    The probability of grid failure (caused by the damage) is medium at present; in risk events the consequences for the Company can range from minor to medium. To reduce the negative effect of risk events and minimize operating risks all major facilities of the company are insured. Besides, a whole range of measures is implemented to guarantee the trouble-free appropriate work of the equipment and facilities:

    1. An automated asset management system to optimize the work, maintenance and repairs of grid assets and to regulate investment has been introduced.
    2. Innovative equipment is being introduced as part of modernization of grid assets to reduce the wear and tear of the power facilities.
    3. A long-term reliability program has been developed and implemented to ensure trouble-free work and system reliability.
    4. Tendering is held for service and procurement organizations in order to achieve higher quality of services and materials, increased responsibility of contractors and reduced costs per unit.

    Industrial risk management of the company is conducted in accordance with federal laws on industrial safety, as well as under control of compliance with industrial safety requirements.

  2. Regulatory risks stemming from state tariff regulation

    Electricity transmission through distribution networks and connection to the power grid are regulated by the state. Thus, the formal approval of tariffs for the Company directly affects the amount of revenue.

    The Russian Government policy has been to contain growth of tariffs for products and services of natural monopolies. A step-by-step reduction in payment for grid connection is provided for by a number of measures approved by the Government Decree No. 1144r dd. June 30, 2013. The tariff increase for electricity transmission is restricted by the pace determined by the forecast of the socio-economic development of the Russian Federation for the relevant year (hereinafter referred to as Forecast) or specific development scenarios for the domestic economy, approved by the Russian Government. The 2014 Forecast accounts for the decision not to index tariffs of natural monopolies, including TGC, and to adjust them to the level of last year’s index of consumer prices growth in the upcoming years.

    Moreover, Federal Law No. 308-FZ On Amending the Federal Law On the Electric Power Industry (hereinafter - Federal Law No. 308-FZ) dd. November 6, 2013, forbids the lease of UNPG facilities to the territorial grid organizations, with the exception of some areas with numerous large industrial customers whose power installations are connected to those facilities (it applies to Belgorod, Kursk, Lipetsk and Tambov regions located within the service area of IDGC of Centre) from January 1, 2014 onwards. For such consumers a special tariff (HV-1) has been introduced valid till July 1, 2017, which takes into account the step-by-step reduction of cross-subsidization. The implementation of Federal Law No. 308-FZ may result in the revenue losses and, as a result, the financial deterioration of the Company and reduction of the Company’s investment program.

    To compensate for the shortfall in income of grid companies, Federal Law No. 308-FZ provides for as little as 7% increase in tariffs for electricity transmission (except for consumers to HV-1) from 1 January 2014 as compared to the level as of December 31, 2013.

    The existing legislation conferred on the Company’s branches Bryanskenergo, Kurskenergo, Orelenergo, Smolenskenergo and Tverenergo the status of suppliers of last resort (hereinafter SLR) in 2013. In addition to providing services in the key areas (electricity transmission and grid connection) the above-mentioned branches fulfill SLR functions, keeping up the current sales premiums established for organizations which performed those functions earlier. The current legislation does not provide for the compensation of the shortfall in income caused by the newly acquired SLR status of local grid operators during the regulatory period when the status was granted.

    To minimize risks, the following measures are taken:

    1. Work is being carried out with Russia’s tariff regulatory bodies to provide compensation for the shortfall in income of the grid operators caused by the implementation of Federal Law No. 308-FZ, through the additional tariff growth for other consumers beyond the forecast by the Ministry of Economic Development.
    2. Regular work on economical justification of the expenses included in the tariffs is being carried out. This comprises the inclusion of the shortfall in income of the previous periods as well.
    3. Systemic efforts to reduce costs and optimize the investment program are made.
    4. Measures are taken in cooperation with the Federal Service on Tariffs and tariff regulating regional bodies to amend the current legislation of the Russian Federation in the area of price setting for natural monopolies aimed at taking into account the interests of grid operators while setting tariffs for the retail market.
    5. Negotiations are held with the senior management of the companies that won the status of a SLR after the competition organized by the Ministry of Energy, focused on:
      • raising funds through involving credits facilities in order to compensate for shortfalls of payment to IDGC of Centre for the power transmission services, caused by cash deficiency due to the slow signing energy supply contracts with customers;
      • hiring all employees who are engaged in energy retail in the branches of IDGC of Centre to avoid shortfalls in the Company’s income.
    6. Work to conclude “direct” contracts on electric transmission with large consumers is conducted to minimize possible risks of payment shortage on the part of companies that were conferred the status of a SLR supplier after the tender held by the Ministry of Energy.
  3. Environmental risks

    Environmental risks are possible harmful emissions from fixed facilities (in case of IDGC of Centre the risk is insignificant) and transport systems. To prevent the possible negative impact on the environment, the Company controls the toxicity of exhaust emissions from vehicles, so that these risks are minimal and might provoke just minor consequences for the Company.

    Environmental risks can also consist in possible leakage of transformer oil at substations lacking oil receivers into rivers and lakes with the surface water run-off. This can lead to oil contamination of fisheries. The probability of these risks is estimated as insignificant, with low consequence probability for the Company.

    The Environmental Policy of IDGC of Centre approved by the Board of Directors is a tool to reduce ecological risks and to improve environmental security by ensuring reliable and environmentally friendly transmission and distribution of energy and an integrated approach to the use of natural energy resources. In the course of realization of the environmental policy, special attention is rendered to the importance of recycling various hazard classes of waste. Such an approach significantly reduces the risk of adverse impact of toxic substances on the soil and, consequently, on human health.

    A promising long-term program of IDGC of Centre contributes to environmental risk reduction through replacing 6-10 kV oil circuit breakers with vacuum ones and installing reclosers, which reduces the technological cycles of dielectric oils and exclude their contact with the environment and the necessity to bear the costs of recycling of the used oils.

    As part of the activities envisaged by the long-range program of technical renovation and reconstruction, the Company is carrying out the replacement of electrical components and assemblies with advanced equipment designed to ensure high environmental safety.

  4. Profit risks caused by lack of payment discipline of power supply companies or a decrease in energy consumption

    The main consumers of IDGC of Centre are retail companies supplying electricity to ultimate customers. The main risk involves the probability of increased receivables resulting from the breaches of the payment discipline of ultimate customers and the need for additional credit resources. There is a risk of cash shortage at the Company’s accounts caused by the time gap during the payment from the retailer and the need to finance current operations. The risk in this case is moderate. To reduce the risk and minimize its consequences, managers are conducting a prudent credit policy and the policy of managing receivables to optimize their size and promote debt collection. The Company also does claims-related work to collect overdue receivables and implements a policy presupposing direct contracts with consumers of electricity.

    As the revenues of IDGC of Centre are affected by the trends in regional energy consumption, there is a risk of a revenue shortfall due to the inability to reach the energy consumption targets initially set by individual large customers. Now the probability of this risk is assessed as low and might provoke consequences for the Company classified from moderate to grave.

  5. Risks associated with the floating maximum level in electric energy transmission services

    Risks associated with the floating maximum level of service provision are presently expressed by the following circumstances:

    • Some regions and municipal entities of the Russian Federation have no relevant economic development plans, which are expected to indicate the dynamics of energy consumption growth for a certain period;
    • Power consumption of the Russian economy in general may be reduced by the adoption of Federal Law No. 261-FZ On Energy Saving and Increasing Energy Efficiency and an Amendments to Certain Legislative Acts of the Russian Federation dd. November 23, 2009 and by the introduction of social norms of consumption;
    • Power consumption of the Russian economy may be reduced due to a future economic recession/crisis;
    • Power consumption may be reduced due to a downturn in the markets of major industrial consumers;
    • Another risk is a drop in consumer capacity caused by changing the day and night load curve (load shift to the night hours without a decrease in consumption).

    These circumstances make it impossible to accurately forecast the needed investment in the industry, which would be able to meet the power demand in the mid-term and in the far perspective. Besides, these circumstances may result in a drop in the profit element of the budget of IDGC of Centre in the long run. This risk imperils the compliance with the commitment of providing electricity transmission services.

    The Company estimates the probability of these risks as moderate, bearing moderate consequences to the Company’s activities. To minimize the risk, the following steps are being taken:

    • cooperation with the Russian regional state governments and local authorities to develop mid- and long-term plans for the economic development of the regions;
    • diversifying the services portfolio of the Company.
  6. Risks associated with a lack of qualified workforce in the industry

    The industry is currently witnessing a reduced inflow of qualified personnel. In case this current trend is carrying on, the Company may face a shortage of qualified personnel in its service areas. This risk is estimated as moderate in the long term, with consequences for the Company ranging from minor to moderate. In order to minimize this risk, the Company is undertaking the following steps:

    • The Company supports regional secondary and higher institutions that train the personnel for the industry, creates and renders financial assistance to the programs aimed to train power engineering specialists with subsequent employment of the qualified specialists;
    • The Company implements programs to boost motivation and reduce the staff turnover, it seeks the ways to offer incentives other than financial ones, and it encourages collective bargaining.
  7. Risks associated with possible fluctuations in prices for utilities and services used by IDGC of Centre (assessed separately for domestic and foreign markets) and their impact on the Company’s activities and commitments under securities obligations

    Risks of a price increase for accessories, equipment and other materials may emerge while operating the facilities.

    These risks are primarily caused by inflation processes and can be minimized by implementing the following measures:

    • increased operational efficiency due to the implementation of programs to reduce production costs (creating a competitive environment in the area of procurement of work and services, cost of maintenance and overhaul projects optimization, etc.);
    • centralized procurement (resulting in “economies of scale” from the purchase procedure);
    • increased share of local equipment and locallymanufactured utilities (decreasing dependence on currency exchange rates).

    At the current inflation rate, the impact of these risks on the Company is moderate with the medium risk probability.

  8. Risks linked to possible fluctuations in the costs of IDGC of Centre services in foreign markets and their impact on the Company’s activities and commitments under securities obligations

    IDGC of Centre does not operate in the foreign market and does not have any plans to start, the volume of accessories and equipment purchased abroad is insignificant. Therefore, the above-mentioned risks cannot have a profound impact on the Company.

    The risk of IDGC of Centre non-fulfilling its obligations to security holders (owners of common stock and exchange bonds) as caused by the changing industry conditions is minimal.

COUNTRY AND REGIONAL RISKS

Country risks

Currently the sovereign rating of the Russian Federation is “BBB+” (in the sovereign currency, as rated by Standard & Poor’s), “BBB” (by Fitch) and “Baa1” (by Moody’s), while the outlook is “stable”.

Financial problems or stronger fear of investment risks in emerging economies have reduced the foreign investment influx to Russia, caused an outflow of foreign capital, and had an adverse impact on the Russian economy. Moreover, the Russian economy is particularly vulnerable to changing global prices for natural gas and oil. Consumer prices in the country are still a destabilizing factor. All these factors can reduce access of the IDGC of Centre to capital and have a detrimental effect on customers’ purchasing power. The Russian Government is implementing the policy of containing the growth of tariff for products and services of natural monopolies, which can lead to the shortfall in funds for the Company’s investment program. Moreover, in the mid-term some amendments will be made to the legislature in what relates to the measures to tackle the problem of crosssubsidization in the power industry.

Risks are assessed as high, with moderate to critical consequences for the Company’s activities.

To minimize the risks mentioned above, the IDGC of Centre has been working hard to reduce internal costs, streamline the investment program and carry out a prudent borrowing policy.

Political risks are beyond the Company’s control because of their scale, but the Company seeks to minimize them by active cooperation with superior and regulatory organizations to jointly affect the development of the industry.

Regional risks

IDGC of Centre operates in the Central Federal District of Russia, a well-developed region, the center of financial and political activity.

The 2012-2013 Investment Rating, which was compiled by the rating agency “Expert RA”, assesses the investment potential of Russia’s regions and regards 7 out of 11 regions where IDGC of Centre operates as regions with moderate investment risks and considerable investment opportunities, while the remaining four regions (the Belgorod, Voronezh, Lipetsk and Tambov regions) are rated as regions with minimal investment risks.

Major regional risks for IDGC of Centre generally include:

  • failure of the state agencies in charge of tariff-setting to accept expenditure proposed by the Company as economically justified and integrate it into the tariff;
  • reduced energy consumption by large regional plants and manufacturing facilities.

These circumstances may have a significant impact on the Company’s major investment program, and there still is a strong probability of such developments. To reduce the influence of regional risks on the investment program, the Company cooperates with state agencies and other stakeholders to monitor and manage the stakeholders’ investment decisions in what concerns the Company’s investment policy. The Company also engages in optimizing the financing of the investment program by reducing internal costs.

A possible change of regional authorities along with the change of the existing model of cooperation is the key political risk to the Company on the regional level. The most obvious consequences for the Company in these cases are: low regional tariffs lacking economic justification, and absence of the regional authorities’ support for the integration of IDGC of Centre into the municipal power grid.

Now the risk probability is assessed as very low, with the consequences for Company estimated as minor to moderate.

To minimize these risks, the Company is striving to cooperate with regional and local authorities in working out long-term development programs in the regions where the branches operate, and seeks the senior authorities’ consent to settle its regional issues.

Risks from possible military conflicts, national and local emergencies and strikes in the regions where IDGC of Centre is a registered taxpayer and/or operates

The probability of conflicts and the state of emergency in the country or the regions where the Company operates is quite low. Should a military conflict arise, the Company is exposed to serious risks of forcing out of action of its major assets.

Risks related to the geography of the country and the region where IDGC of Centre is a registered taxpayer and/ or operates, including higher risk of natural disasters, potential interruption of transportation due to remoteness and/or limited accessibility

The geography of the region in which the Company operates entails the risk of natural disasters in autumn and winter seasons (AWS). These risks are assessed as high. The Company makes a set of steps to prepare the grid for the AWS, with certificates of preparedness to AWS issued for each branch. Efforts are constantly made to speed up the relief operations after the disaster in autumn and winter.

Managers are to submit to the Board a report on the preparations for the autumn and winter, as well as a performance report after the AWS.

FINANCIAL RISKS

The Company activities may meet a shortage of investment funds or funds for business operations.

The most significant financial risk factors stem from the imperfections of the retail energy market and are listed in the Industry risks section. However, there are an additional number of risk factors that could affect the Company’s financial and operating activities.

Inflationary risks

Inflation could hurt the Company’s financial and economic performance through a drop in the real value of receivables, rising interest rates payable on loans, and higher construction costs under the investment program.

The current inflation will not have a significant impact on the Company’s financial state. According to plans of the Central Bank of Russia to curb inflation, and to its forecast scenario indicators for the closest future, we may believe that inflation will not have a considerable effect on the Company’s financial performance.

Currency risks

Any unwelcome fluctuations in the foreign currencies – ruble rate could affect the indicators of the Company’s operating efficiency and investment effectiveness.

The Company is not highly susceptible to currency risks, because operations with its counteragents are carried out in Russian rubles only. Nonetheless, since the Company imports some goods and equipment, a considerable leap in the exchange rate could make imports more expensive. The Company is therefore seeking to replace imports with locally manufactured goods and to sign long-term contracts to preclude any rise in the cost of the acquired goods.

Interest rate risks

Changes in the Central Bank of Russia refinancing rate reflect the macroeconomic situation and affect the cost of using credit facilities. Growing borrowing costs could trigger unexpected increases in the cost of servicing the Company’s debt.

In order to minimize the risk, the Company conducts a prudent borrowing policy aimed at building a balanced loan portfolio and minimizing the cost of servicing its debt.

Liquidity risks

The Company’s activity is exposed to risks leading to the dry-up of its liquidity and undermining financial stability. Cross-subsidization among consumer groups and poor payment discipline in the retail energy market expose the Company to the most serious risks.

The state’s tariff policy to curb the tariff rise for the public brings about increased cross-subsidization, mostly affecting large consumers that have signed last mile contracts. The shift of big industrial consumers to conclude direct agreements with FGC UES generates shortfalls in the Company’s income.

Poor payment discipline of the contractors results in high accounts receivable, including overdue payments. The main factors affecting the payment discipline were the discrepancy in contracted capacity with retail companies, as well as the improper use of funds for electricity supply by the companies deprived of the SLR status.

The Company can be unable to meet financial and other conditions stipulated in loan agreements should these risk factors come into play. In order to reduce the probable risk of these developments, the Company regularly reviews its capital structure and determines the best terms of borrowing, working at the same time to improve the structure of its floating capital.

Influence of financial risks on financial statements

Changes in prices for electricity transmission, first of all, affect the total revenue of the Company and will have a significant impact on the net profit of the issuer.

Inflation, which results in the increasing price of materials used in production and raw materials, could have a crucial impact on the balance sheet total due to the rising accounts payable and decreasing accounts receivable.

It may as well have a substantial impact on the net profit of the issuer, as the issuers’ capacity of raising power transmission price are limited by the annual state regulation, that is, the issuer cannot adjust them to the inflation level, while its costs, which are mainly denominated in rubles, directly depend on the inflation rate.

Of all the indicators of financial statements revenue, net income, the size of receivables and payables are subject to the most drastic changes should the risk events come.

COMPLIANCE RISKS

Compliance risks, particularly posed by ambiguities in tax legislation interpretations, could lead to incorrect tax calculation and tax payments with the relevant penalties imposed by the tax authorities. To reduce these risks, the methodology for accurate tax calculation is constantly reviewed and updated and its compliance with the working legislation is regularly checked.

Moreover, the Company runs the risk of legislation amendments and faults in legal paperwork and legal support. To minimize these risks, the Company’s activities are subject to mandatory preliminary legal expertise.

The Company is also exposed to the risk of a shareholders’ appeal of large transactions and of related party transactions (if such transactions were carried out without proper preliminary approval of the Board of Directors or the General Meeting of Shareholders, or approved with procedural breaches).

To minimize these risks, a mandatory preliminary legal analysis of transactions is carried out as part of the contractual work to identify the need for corporate procedures required by the working law and/or the Company’s charter. If necessary, the transactions are submitted to the relevant Company authorities.

To minimize the risks associated with shareholders (in particular, the risk of “corporate blackmail” by shareholders, the risk of unwelcome actions on the part of shareholders which threaten general meetings of shareholders in future), the professional registrar LLC “Register-RN” keeps the register of shareholders. The Company carries out a range of measures aimed at improving information exchange with shareholders and at full compliance with the rights and interests of the latter (the disclosure of information in accordance with regulations, scheduled meetings with the company’s shareholders to clarify relevant current issues, and compliance with corporate procedures and internal documents).

Given that IDGC of Centre does not operate abroad and does not intend to launch any operations outside the Russian Federation, there are no legal risks caused by the activity on the foreign markets.

Risks posed by changes in currency regulation

The Company’s exposure to risks posed by changes in the currency legislation is minimal, since the Company does not intend to operate abroad, and foreign exchange transactions are insignificant and unable to seriously affect the activities.

Risks posed by changes in tax legislation

Tax regulations often have vague wording or include terms which are not clearly and legally defined. Moreover, the official clarifications exercised by Ministry of Finance and the Federal Tax Service of the Russian Federation occasionally fail to fully cover tax legislation.

Tax authorities are charged with establishing the rules and mechanisms for compiling and issuing tax statements. They are entitled to impose additional taxes and fees, to introduce the late payment charge, to impose significant penalties, which seriously increases tax risk probability. The Company complies fully with the tax legislation relevant to its operations. Therefore, this risk is assessed as insignificant.

If taxation schemes or terms are changed, the Company will integrate these changes in its financial and economic activities.

Risks posed by changes in customs regulations and duties

Changes in customs regulations and duties do pose no risks to the Company as the Company does not operate abroad and does not intend to launch any operations outside the Russian Federation.

Risks posed by changes in licensing requirements of the IDGC of Centre major activity or licensing rights to use the objects with a restricted circulation capacity (including natural resources)

The preparation of documents necessary for obtaining or renewing the license may take more time because of possible changes in licensing requirements, which can also create the need to comply with the new regulations. However, this risk should be considered insignificant, unless obtaining or renewing the license, or performing operations subject to licensing, demand the compliance with the excessively stringent requirements that the Company is unable to meet or that are too costly.

If licensing requirements change, the Company will take the necessary steps to obtain the appropriate licenses and permits.

Risks posed by changing legal practices related to the activities of IDGC of Centre (including licensing), which can adversely affect its performance and its claims in on-going litigation

Changes in legal procedures affecting the Company (including licensing issues) are unlikely and will not have a considerable impact on its operations.

If the changes in legal practices relate to the Company’s major activity, the Company is resolved to plan its financial and economic processes accordingly.

RISKS LINKED TO THE ISSUER’S ACTIVITY

Risks posed by the Company’s claims currently in litigation

In 2013 a number of regional retail companies operating in the service area of the IDGC of Centre, were deprived of the SLR status. The insolvency of those organizations caused both lenders and debtors themselves file bankruptcy petitions.

As a result, IDGC of Centre laid down the requirement to include retailers’ debts in the list of creditors’ claims. However, it is unlikely that the requirements of the Company in the insolvency process will be satisfied in full by the bankrupt’s assets.

Risks posed by the inability to renew the issuer’s license for a certain activity or use of objects with a restricted circulation capacity (including natural resources)

The Issuer assesses the risks posed by the inability to renew the issuer’s license for a certain activity or use of objects with a restricted circulation capacity (including natural resources) as low.

Risks posed by the issuer’s liability for the debts of third parties, including the Issuer’s subsidiaries are deemed as

insignificant as the Issuer does not hold any debt obligations of third parties.

Risks posed by the potential loss of customers who account for at least 10 percent of the Issuer’s total sales revenue (work, services)

Service contracts for power transmission are mandatory for grid operators. Therefore, there are no risks posed by the loss of customers who account for at least 10 percent of the total sales revenue (work, services).

There are no other risks posed by the activities of IDGC of Centre and specific to the Company to be included in this report.