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

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

Vitaly Butenko Chief Strategy Officer
March 2008
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DTEK - THE LARGEST PRIVATELY OWNED COMPANY IN
THE UKRAINIAN POWER SECTOR
The first and only private vertically integrated
power utility company in Ukraine
COAL PRODUCTION
GENERATION
POWER DISTRIBUTION
Coal production in Ukraine 75.5 Mt
Electricity output from WEM 161.3 TWh
Electricity generation by TPPs in Ukraine 73.5
TWh
DTEKs market share 7.6
DTEKs market share 20.9
DTEKs market share 27.1

• Pavlogradugol
• Komsomolets Donbassa mine

• Service-Invest
• PES Energougol

• Vostokenergo

for the year 2007 excluding export
Source DTEK, Energobusiness
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OPERATING STRUCTURE
DTEK
COAL
GENERATION
DISTRIBUTION
OTHER
Vostokenergo, LLC (3 TPPs)
COAL MINING
PES-Energougol, OJSC
Sotsis, LLC
Komsomolets Donbassa, OJSC (1 mine)
Service-Invest, LLC
Service Enterprise, LLC
Pavlogradugol, OJSC (10 mines)
Ecoenergoresurs, LLC
COAL ENRICHMENT (5 plants)
Revenue structure for 2007 (in US MM)
COAL
GENERATION
DISTRIBUTION
OTHER
Source DTEK
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COMPANY HISTORY
2007
DTEK receives its first credit ratings from
Moodys (B2) and Fitch (B). Both ratings are one
notch below Ukraines sovereign rating. At the
end of 2007 the Company buys two coal enrichment
plants Oktyabrskaya CEP and Dobropolskaya CEP.
2006
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.
2005
DTEK Corporation is officially registered on July
6, 2005. As a result of DTEKs 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 Companys enterprises is
completed.
2004
In 2004, SCM publicly announces plans to
establish DTEK as Ukraines 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.
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.
2002
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LARGEST PRIVATE PLAYER IN GENERATION
Revenue (US MM)
Output (TWh)
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• 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.

Net profit (US MM)
1
State-owned
DTEK
Private
Source DTEK, Energobusiness, Companys reports
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DISTRIBUTION MARKET IN UKRAINE
Revenue (US MM)
Purchases (TWh)
3
4
Net profit (US MM)

• 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.

1
State-owned
DTEK
Private
Source DTEK, Energobusiness, Companys reports
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UKRAINIAN POWER MARKET STRUCTURE (2007)
TYPE OF POWER PLANT (by output to WEM)
OWNERSHIP STRUCTURE (by output to WEM)
Hydro
GENERATION
CONSUMPTION STRUCTURE
OWNERSHIP STRUCTURE (by purchases from WEM)
DISTRIBUTION
Wholesale electricity market
Source DTEK, Energobusiness,
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POWER MARKET IN UKRAINE TODAY
?
PROS
Generators competitive tariff (TPP)
Generators fixed tariff (NPP, HPP, CHPP)

• 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.

Market operator / WEM (Energorynok)
?
CONS
System and high-voltage networks operator
(Ukrenergo)

• 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.

Distributors (oblenergo network owners)
Independent suppliers
Export operator (Ukrinterenergo)
Ukrainian consumers
Export
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GOVERNMENT INITIATIVES FOR MARKET REFORM - A
TWISTED ROAD
FREE MARKET
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.
2002
NAK ECU is created to manage state owned stakes
in generation and distribution companies. A
return to government controlled vertically
integrated utility.
EBRD project Ukraine Tariff reform for
transmission and distribution networks work
groups meet occasionally.
2007 - 2008
2004
2003 - 2007
1996

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

World Bank Project implementation of WEM
development concept (2003-2005 / 2007). Attempt
to resuscitate the concept for WEM development
making.
t
TOTAL CONTROL
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EUROPE POWER MARKET MODELS OVERVIEW

• 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.

Bi-lateral contracts without Power Exchange
Pool markets with bi-lateral contracts with
physical delivery
State-owned regulated vertically integrated
monopolies
Bi-lateral contracts with Power Exchange
Pool markets without bi-lateral contracts with
physical delivery
Level of liberalization
Free market
Regulated markets
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EUROPE DISTRIBUTION REGULATION

• 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.

Price Cap
Revenue Cap
Rate of Return
Cost
Incentive regulation
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SUPPLY / DEMAND CURVES ARE CROSSING
Capacity surplus buyers market

• 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 deficit producers market

• 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.

Needs in reconstruction new capacities (GW)
TOTAL
Source DTEK / DTEK estimate
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TIME BOMB EFFECT?
TODAY

• 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.

Price
Time
TOMORROW
Price

• 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.

Time
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DISTRIBUTION VS REGULATORS DIVERGENCE OF
INTERESTS
COST (now)
INCENTIVE BASED TARRIFFS (tomorrow)

• 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 tomorrows tariffs.

Management
Minimum allowable reliability level
Regulator
Investments in reliability/quality
Capitalization
Operating costs
Operating costs
Investments in reliability/quality
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BALANCE OF INTERESTS THE KEY TO POWER SECTOR
DEVELOPMENT

• 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 UKRAINES POWER MARKET

• 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

• 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