THE ROLE OF THE PRIVATE SECTOR IN REFORMING THE UKRAINIAN POWER MARKET

March 2008

Vitaly ButenkoChief Strategy Officer

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DTEK’s market share7.6 %

DTEK’s market share7.6 %

DTEK’s market share27.1 %

DTEK’s market share27.1 %

COAL PRODUCTION

GENERATION POWER DISTRIBUTION

Electricity output from WEM** – 161.3 TWh*

Electricity generation by TPPs in Ukraine – 73.5 TWh*

DTEK’s market share20.9 %

DTEK’s market share20.9 %

Pavlogradugol Komsomolets Donbassa mine

Vostokenergo Service-Invest PES Energougol

DTEK - THE LARGEST PRIVATELY OWNED COMPANY IN THE UKRAINIAN POWER SECTOR

The first and only private vertically integrated power utility company in Ukraine

2* for the year 2007** excluding export

Coal production in Ukraine – 75.5 Mt*

Source: DTEK, Energobusiness

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OPERATING STRUCTURE

DTEK

COAL GENERATION DISTRIBUTION OTHER

Komsomolets Donbassa, OJSC (1 mine)

Pavlogradugol, OJSC (10 mines)

COAL MINING

COAL ENRICHMENT(5 plants)

Vostokenergo, LLC(3 TPPs)

PES-Energougol, OJSC

Service-Invest, LLC

Sotsis, LLC

Service Enterprise, LLC

Ecoenergoresurs, LLC

Revenue structure for 2007 (in US $’MM)

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COAL GENERATION DISTRIBUTION OTHER

Source: DTEK

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COMPANY HISTORY

2002

2004

2005

2006

A group of 15 enterprises ranging from coal production and enrichment to electricity supply is combined together as Donbass Fuel-Energy Company (DTEK). The core of the DTEK Group is formed by three key companies: power generating company Vostokenergo, power supplying company Service-Invest (total length of electric networks is over 2 000 km), and coal mine Komsomolets Donbassa. Coal processing is conducted at DTEK by the coal enrichment plant – Mospinskoye Coal Enrichment Plant Ltd. Tekhrempostavka Ltd., which is also a structural unit of DTEK, deals with the upgrade and reconstruction of power equipment.

In 2004, SCM publicly announces plans to establish DTEK as Ukraine’s first private vertically integrated company in the power sector. DTEK acquires State Holding Company Pavlogradugol OJSC comprised of 10 mines and 2 coal enrichment plants in the Western Donbass region.

DTEK Corporation is officially registered on July 6, 2005.As a result of DTEK’s incorporation, a single center of responsibility for financial and production performance is set up in the format of a corporation, unified management processes are introduced, and the vertical integration of the Donbass Fuel-Energy Company’s enterprises is completed.

In 2006, DTEK acquires PES-Energougol OJSC, a company supplying power to 25.5 thousand consumers, with over 1 000 km of overhead transmission lines and 380 step-down sub-stations.

2007DTEK receives its first credit ratings from Moody’s (B2) and Fitch (B+). Both ratings are one notch below Ukraine’s sovereign rating. At the end of 2007 the Company buys two coal enrichment plants: Oktyabrskaya CEP and Dobropolskaya CEP.

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5

LARGEST PRIVATE PLAYER IN GENERATION …

Revenue (US $’MM)

Net profit (US $’MM)

Output (TWh)

State-owned

PrivateDTEK

5

87.3

18.1 15.3 13.9 13.7 9.4 6.1

Energo-atom

DTEK Dnipro-energo

Center-energo

Zapad-energo

Ukrgidro-energo

Donbass-energo

# 2

$1,640

$892 $758 $716 $679

$291 $147

Energo-atom

DTEK Dnipro-energo

Zapad-energo

Center-energo

Donbass-energo

Ukrgidro-energo

# 2

$126

$75 $61

$24 $13 $10 $5

DTEK Energo-atom

Ukrgidro-energo

Dnipro-energo

Center-energo

Zapad-energo

Donbass-energo

# 1

DTEK is the second largest generator of electrical power in Ukraine after State Nuclear Power Generation Company (Energoatom) based on the production volumes in 2007.

DTEK is the #1 thermal power producer in Ukraine.

Revenues from power generation for 2007 reached $892MM, the second highest revenue among the power generating companies in Ukraine.

DTEK firmly holds #1 position in Net Profit among other power generation companies of Ukraine with a record $126MM of Net Profit booked in 2007.

Source: DTEK, Energobusiness, Company’s reports

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$1,400

$569 $505 $470 $283 $212 $190

Dnepr-oblenergo

Zaporoje-oblenergo

DTEK Donetsk-oblenergo

Kharkov-oblenergo

Crym-energo

Lvov-oblenergo

28.8

11.4 11.39.2

5.8 4.7 4.0

Dnepr-oblenergo

Donetsk-oblenergo

Zaporoje-oblenergo

DTEK Kharkov-oblenergo

Crym-energo

Lvov-oblenergo

… & DISTRIBUTION MARKET IN UKRAINE

Revenue (US $’MM)

Net profit (US $’MM)

Purchases (TWh)

State-owned

PrivateDTEK

6

# 4# 3

# 1

In distribution, DTEK is in the top 5 Ukrainian distribution companies with a total 9.2 TWh of power transmitted in 2007.

DTEK holds #3 position in Revenues and #1 position in Net Profit based on the results of its distribution business in 2007.

$16

$6 $4 $3 $2 $2

$(59)

DTEK Dnepr-oblenergo

Zaporoje-oblenergo

Kharkov-oblenergo

Crym-energo

Lvov-oblenergo

Donetsk-oblenergo

Source: DTEK, Energobusiness, Company’s reports

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UKRAINIAN POWER MARKET STRUCTURE (2007)

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TYPE OF POWER PLANT

(by output to WEM*)

* Wholesale electricity market

Nuclear87.3TWh

50%Thermal67.1TWh

38%

Hidro9.6TWh

6%

Other11.3TWh

6%

OWNERSHIP STRUCTURE

(by output to WEM*)

State155.3TWh

89%

Private20.0TWh

11%

State102.5TWh

60%

Private68.2TWh

40%

CONSUMPTION STRUCTURE

Industry83.6TWh

53%

Agriculture & transport13.4TWh

8%

Household & non-industrial

51.3TWh33%

Export9.2TWh

6%

Source: DTEK, Energobusiness,

OWNERSHIP STRUCTURE

(by purchases from WEM*)

GEN

ER

ATIO

ND

ISTR

IBU

TIO

N

Hydro

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POWER MARKET IN UKRAINE: TODAY

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Generators: competitive tariff

(TPP)

Generators: fixed tariff (NPP, HPP,

CHPP)

System and high-voltagenetworks operator (Ukrenergo)

Market operator / WEM(Energorynok)

Distributors(“oblenergo” –

network owners)

Independentsuppliers

Export operator(Ukrinterenergo)

Ukrainianconsumers

Export

Simple market structure

Simplified system for setting tariffs

Ease of control over price fluctuations

Centralized function of system load planning reduces the risk of system overload or failure.

PROS

Lack of incentive to invest

Frequent administrative interference

Cross subsidies

No support for ensuring adequate investor returns in distribution companies (“oblenergos”)

Operational efficiencies are not rewarded

No hedging or risk protection for non-payment

No market for auxiliary services

State control over imports, exports and transit.

CONS

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GOVERNMENT INITIATIVES FOR MARKET REFORM - A TWISTED ROAD

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19962004

2002

POOL system is created – vertically integrated utility is broken up into separate parts:- generation- WEM- transmission- distribution.

Concept of WEM development approved by the Cabinet of Ministers – the declared gradual transition to a bi-lateral contract model has not materialized. To date, further analysis and planning is required to ensure successful implementation.

NAK ECU is created to manage state owned stakes in generation and distribution companies.

A return to government controlled vertically integrated utility.

World Bank Project – implementation of WEM development concept (2003-2005 / 2007). Attempt to “resuscitate” the concept for WEM development making.

EBRD project: “Ukraine: Tariff reform for transmission and distribution networks” work groups meet occasionally.

FREE MARKET

TOTAL CONTROL

9

t

2003 - 2007

2007 - 2008

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EUROPE: POWER MARKET MODELS OVERVIEW

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Free marketRegulated markets

Bi-lateral contracts with Power Exchange

Bi-lateral contracts without Power Exchange

Pool markets with bi-lateral contracts with physical delivery

Pool markets without bi-lateral contracts with physical delivery

State-owned regulated vertically integrated monopolies

Level of liberalization

More than 70% of European

countries have adopted a market

model which is based on bi-

lateral contracts between power

producers and consumers.

Less than 30% of European

countries are still using a Pool

Model.

Trend continues toward more

efficient bi-lateral contract based

market models.

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EUROPE: DISTRIBUTION REGULATION

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Revenue Cap

Rate of Return

Cost +Price Cap

Incentive regulation

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More than 80% of Europe's

national markets are using

various types of incentive

regulation.

The most widely used are

“Revenue Cap” and “Rate of

Return”.

Despite the variety of methods

used, the key basic principals that

form the basis for such regulatory

environments are:

To guarantee return on

capital

Opportunity to receive

additional rent via operating

efficiencies.

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SUPPLY / DEMAND CURVES ARE CROSSING

Ukrainian power generation market has traditionally been regarded as having surplus capacity.

One-buyer pool system allowed to minimize the price of energy for the end consumer by mixing the cheap energy from HPP and NPP with the more expensive supply from TPP.

Surplus capacity provides little incentive or sense of urgency for the state to pursue a more aggressive tariff policy for power generation expansion and proper maintenance cost recovery, instead opting to keep tariffs at the minimum level sufficient to cover operating costs.

Capacity surplus will run out in 2009, after which point the risk of peak loads exceeding available working capacity in the system will increase substantially.

Existing model does not stimulate any serious investment in the sector.

Estimated capex required to meet the growing demand for generation capacity ranges from $15Bn to $20Bn* over the next seven years.

State is incapable of meeting the capital requirements needed to sustain the supply level.

Private capital is the answer but will be impossible to attract without substantial structural changes to the regulatory environment and existing market model.

Capacity surplus – “buyers” market

Capacity deficit – “producers” market

1212

23

3

4

5

5

5

27

0

5

10

15

20

25

30

2009 2010 2011 2012 2013 2014 2015 ИТОГО 2009- 2015

Needs in reconstruction & new capacities (GW)

* Source: DTEK / DTEK estimate

TOTAL

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TIME BOMB EFFECT?

Price

Time

Price

Time

The “Detonating mixture” … State control of generation Price control via administrative

methods (operating cost + minimum capex)

Unstable and constantly changing political environment leading to more populist policies and decisions

… will lead to uncontrolled capacity deficit for the entire power sector, sharp “emergency” increases in tariffs and increased threat of energy dependence.

TODAY

Tariff setting mechanisms based on the supply/demand equation and the introduction of a competitive environment in generation will lead to a sustainable increase in capital inflows into the sector. Increased efficiency and reliability of power supply in the long term.

State will continue to control the level of competitive pressure on tariffs as well as influence the market by using NPP and HPP reserves.

TOMORROW

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DISTRIBUTION VS REGULATORS: DIVERGENCE OF INTERESTS

Investor puts pressure on management to cut costs in order to increase capitalization.

State provides incentives for the owner to improve efficiency while maintaining adequate level of reliability and security.

State monitors the reliability and stability of networks on an on-going basis while the company focuses on long-term efficiency, guaranteed by the regulatory environment.

“Cost +” provides no incentive to keep costs down and network reliability issues are typically addressed via tariff increases.

The state has no effective means to oppose tariff increases without jeopardizing the reliability of the network.

Assets are obsolete. Reinvestment is difficult due to the uncertainty of “tomorrow’s tariffs”.

Op

era

tin

g c

ost

s

Invest

men

ts in

re

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ility

/qu

alit

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Management

Regulator

COST + (now) INCENTIVE BASED TARRIFFS (tomorrow)

Minimum allowable reliability level

Cap

italiz

ati

on

Op

era

tin

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ost

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Invest

men

ts in

re

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/qu

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BALANCE OF INTERESTS: THE KEY TO POWER SECTOR DEVELOPMENT

PRIVATE SECTOR INTERESTS CONSUMER INTERESTS

Required return on capital

Long-term value growth

Investments and property rights protection

Consistent and transparent rules

Lower tariffs

Reliable and high quality power supply

Reserve capacity for business growth

Predictable tariff performance

ROLE OF STATE REGULATORY INSTITUTIONS

Antimonopoly control

Lower cost stimulating environment

Control of quality and reliability of supply

Environmental protection

Provide for open market driven competitive tariff setting mechanism

Allow for investment component to be included in transmission rates

Prevent cross subsidies

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PRIVATE CAPITAL – IMPETUS FOR PROGRESSIVE CHANGE IN UKRAINE’S POWER MARKET

Private Investors will bring to the Sector…

• operational experience• cost reduction• increased production volumes• auxiliary services

State and consumers will benefit from…

• increased capital investments• strengthened energy security• improved quality and reliability of power

supply

Private Investors will come to the Sector if there is…

• transparent and meaningful privatization• clear and consistent rules of the game• protection against unfair administrative interference

INVESTMENT

INCREASED PRODUCTION

PRIVATIZATION

AND

ENERGY MARKET

LIBERALIZATION

COST REDUCTION