management report of pjsc rosseti 2016...6 key results in 2016: yantarenergo completed the largest...

1

MANAGEMENT REPORT OF PJSC ROSSETI

2016

2

Table of Contents

1. Position of the Company in the Energy Industry ................................... 3

2. Operating Overview ................................................................................... 4

3. Innovation ................................................................................................... 5

4. Economic performance ............................................................................. 7

5. ROSSETI Shareholding Structure and Share Market ........................... 18

6. Corporate Governance ............................................................................ 20

7. Risk Management ..................................................................................... 28

8. ROSSETI Group Structure ....................................................................... 36

9. Responsibility Statement ........................................................................ 38

10. Glossary .................................................................................................... 39

11. Contacts .................................................................................................... 40

12. Application ............................................................................................... 41

3

1. Position of the Company in the Energy Industry

ROSSETTI (RSTI) is the operator of Russia’s energy grids and one of the largest electric grid companies in the world. The Company manages more than 70% of distribution lines and 90% of transmission lines in Russia.

The strategic goals of ROSSETI are to secure a reliable and uninterrupted, high-quality and affordable power supply with the optimal balance of operating and capital expenditures.

ROSSETI is a strategic company, one of Russia’s major infrastructure companies, largely controlled by the government, and acts the government’s agent for the management of the Russian electricity transmission and distribution grid sector.

Due to its geographical location, ROSSETTI interacts with the energy systems of Europe, China, and Central Asia and implements joint projects with them.

4

2. Operating Overview

The core business of the ROSSETI Group is electricity transmission and distribution and network connection.

Operating results of ROSSETI

The ROSSETI Group carries out a package of measures to optimize (reduce) electricity losses.

In 2016, savings totaled 2,397.8 million kWh due to:

■ organizational measures, 1,855.4 million kWh; ■ technical measures, 169.4 million kWh; ■ measures to improve electricity metering, 373.0 million kWh.

The year 2016 witnessed the modernization of more than 198,000 electricity meters (with expenses of 3.0 billion rubles) and the organization of remote data collection at over 163,000 electricity meters.

33,700 reports on noncontractual consumption of electricity totaling 568.0 million kWh were issued and paid in the reporting period, which made it possible to avoid expenses of 2,867.8 million rubles, exclusive of VAT.

Savings arising from measures to reduce electricity losses (in physical terms) in 2016 were 67.0% than planned.

Indicator As of December 31, 2015 As of December 31,

2016 Change, %

Delivery to networks, million

KWH

797,419.7

822,045.0

3.09%

Length of power lines,

thousand kilometers

2,303

2,314

0.48%

Number of substations,

thousand units

490

496

1.22%

Transformer capacity, GVA

761

773

1.58%

5

3. Innovation

ROSSETI is active in pursuing the course taken by the Russian Government toward the modernization of the country’s economy and toward the transition from the extensive to innovative scenario of industrial development. An independent audit of the Company’s innovation compared with its peers showed that ROSSETI’s innovation management system corresponded to international practices.

In late 2016, the Company approved a key document underlying the Group’s innovation, the Innovative Development Program for 2016–2020 with Long-Term Plans Until 2025.

Under the Program, the aim of the electric power sector’s innovative development is to switch over to a technologically new electricity supply with qualitatively new characteristics of reliability, efficiency, accessibility, manageability, and customer orientation in the Russian electric grid sector as a whole.

Key Areas of Innovative Development

Areas of Efficiency Evaluation for Program Implementation

Expected Effects of Program Implementation

■ Switch over to and introduce digital substations rated 35–110 (220) kV on a large scale

■ Switch over to actively adaptive digital grids (Smart Grids) with a distributed intellectual automation and control system

■ Switch over to the integrated efficiency of business processes and to the automation of control systems

■ Use new technologies and materials in the electricity industry

■ Improve workforce productivity

■ Improve the efficiency of production processes, reduce production costs, cut per-unit costs of services

■ Introduce modern production technologies and managerial practices

■ Improve energy efficiency for production

■ Achieve production indicators corresponding to the current level typical of comparable electric utilities from developed countries

■ Reach the technical and technological level of comparable electric utilities from developed countries

■ Form a technological basis for actively adaptive transmission grids and smart distribution grids

■ Enhance energy efficiency, including reducing electricity network losses (achieve the planned indicators of the Program)

Program implementation expenses, million rubles, exclusive of VAT

2016 2017 2018 2019 2020 2021–2025

5,923.0 8,516.0 7,925.0 8,500.0 8,960.0 39,200.0

6

Key results in 2016:

■ Yantarenergo completed the largest and most difficult phase in the automation of the electricity

distribution network in the Mamonovo electric grid district.

■ The large-scale project of the ROSSETI Group’s first digital 110 kV Olimpiyskaya substation of

Tyumenenergo is nearing completion.

■ Under the program to introduce EV charging stations, Mode-3 stations at the Sorochany ski resort

and the Vnukovo-3 airport, six charging stations at Lukoil filling stations, and two stations in Sochi

were installed and put into operation. The program specifies the construction of a total of 250

charging stations by 2018.

■ The “Energy Breakthrough” All-Russia Contest of Innovative Projects was held. The contest of

breakthrough projects in smart energy is designed to combine efforts and expertise from various

areas of science and technology to create the future of energy. It has been held annually since 2013.

255 applications for participation were received in 2016. Some projects were selected during the All-

Russia startup tour organized by the Skolkovo Foundation. As a result, the number of projects

admitted to the final was as follows: 10 projects, including 5 projects in breakthrough technology, 4

projects in technology improvement, 1 project in a separate category.

EnergyNet National Technology Initiative

In September 2016, the Presidential Council on the Economic Modernization and Innovative Development of the Russian Federation approved the EnergyNet road map for the market of integrated systems and services of smart energy. The document contains measures to develop the smart energy market until 2035 and was formulated as part of the National Technology Initiative1 implemented by order of the Russian President.

The EnergyNet Action Plan (Road Map) of the National Technology Initiative was approved in September 2016.

Road Map Stages

Stage 1. Digital infrastructure and services (2016–2020): implement pilot projects based on available scientific and technical reserves, develop the regulatory framework, standards, and educational programs, develop and carry out measures to promote products, services and companies in the markets of the target countries.

Stage 2. Adaptive infrastructure and services (2016–2025): develop critical technologies to create adaptive energy infrastructure and services, implement pilot projects based on a new package of technologies, develop the regulatory framework, standards, and educational programs, develop and carry out measures to promote products, services and companies in the markets of the target countries.

Stage 3. Self-organizing infrastructure and services (2016–2030): initiate studies on the creation of self-organizing infrastructure and services, develop critical technologies, develop the regulatory framework, standards, and educational programs, develop and carry out measures to promote products, services and companies in the markets of the target countries.

1 The National Technology Initiative (NTI) is a governmental program of measures to support and develop promising industries, form

fundamentally new markets, and create the conditions for Russia’s global technological leadership by 2035. In the Address to the Federal Assembly of the Russian Federation on December 4, 2014, Russian President Vladimir Putin mentioned the NTI as a priority of government policy. Nine key markets were selected for the development of the initiative. EnergyNet is an energy market based on technological solutions that ensure the intellectualization and distribution of energy networks (smart grids). The working group on the development and implementation of the EnergyNet road map includes members of ROSSETI’s Board of Directors Oleg Barkin and Oleg Dubnov and member of the Management Board and First Deputy Director General Roman Berdnikov.

7

4. Economic performance

This review is based on the ROSSETI Group’s audited consolidated financial results for the year ended December 31, 2016, in accordance with IFRS.

Consolidated Key Operating Indicators

Indicator 2016 2015 Change

bn RUB bn RUB %

Revenue, including: 904.0 766.8 17.9

■ Electricity transmission and distribution 725.5 650.4 11.5

■ Electricity and capacity sales 74.7 55.9 33.6

Operating expenses 788.3 652.5 20.8

Operating expenses (less impairment of fixed assets and receivables) 730.2 628.8 16.1

EBITDA 265.2 248.9 6.5

Adjusted EBITDA 323.3 273.1 18.4

Adjusted EBITDA margin 35.8% 35.6% 0.2 pp

Net profit 98.3 81.6 20.5

Adjusted net profit 144.8 100.9 43.5

Adjusted net profit margin 16.0% 13.2% 2.8 pp

Net cash flows from operating activities 175.6 156.7 12.1

The ROSSETI Group achieved a growth in all of the principal profitability indicators in 2016. The Group’s net profit totaled 98.3 billion rubles (20.5% up on 2015), while adjusted net profit2 increased to 144.8 billion rubles (43.5% up on 2015).

EBITDA was 265.2 billion rubles, and adjusted EBITDA3 was 323.3 billion rubles, or 6.5% and 18.4% up on 2015 respectively.

Adjusted net profit margin rose by 2.8 percentage points compared with 2015 to 16%, which shows that the Company improved its operating efficiency.

2 Adjusted Net Profit for the reporting period is calculated as the period’s net profit less losses on impairment of fixed assets, impairment of

financial investments, impairment of receivables, and related deferred profit tax liabilities. 3 Adjusted EBITDA is calculated as EBITDA (earnings before interest, tax, depreciation, and amortization for the reporting period) less losses on

impairment of fixed assets, impairment of financial investments, and impairment of receivables.

8

Revenue

The ROSSETI Group’s consolidated revenue totaled 904 billion rubles, or 17.9% up on 2015.

Revenue Structure Analysis

Indicators

2016 2015 Change

bn RUB bn RUB bn RUB %

Electricity transmission and distribution 725.5 650.4 75.1 11.5

Electricity and capacity sales 74.7 55.9 18.8 33.6

Network connection 68.1 34.2 33.9 99.1

Other revenue and government subsidies 35.7 26.3 9.4 35.7

TOTAL 904.0 766.8 137.2 17.9

Revenue from electricity transmission and distribution grew due to increased net electricity delivery, compensation for lost income resulting from the termination of last mile agreements, and the restored smoothing mechanism of minimum regulated revenue in tariff decisions in accordance with the Forecast of the Socioeconomic Development of the Russian Federation. Revenue from network connection services increased due to the completed performance of connection services. The rise in revenue from electricity and capacity sales mainly resulted from increased sales. Other revenue grew largely due to a rise in revenue from the performance of services under construction project contracts for electric grid facilities.

80,3%

8,3%

7,5%

3,9%Electricity transmission and distribution

Electricity and capacity sales

Network connection

Other revenue and government subsidies

9

Government Support

In 2016, ROSSETI did not receive government support, including subsidies. Government subsidies provided for ROSSETI’s subsidiaries totaled 48 million rubles.

ROSSETI’s subsidiaries implement projects financed from federal budget funds4 resulting from their additional share issues.

In addition, a subsidiary of the LENENERGO Group carried out measures in 2016 to set up network connection infrastructure under the Agreement with the Ministry of Energy of the Russian Federation (signed on December 30, 2015, and specifying the procedure for the proper use of 14,975 million rubles in special-purpose funds received from an additional issue of LENENERGO shares).

Operating Expenses

The ROSSETI Group’s operating expenses increased by 20.8% in 2016 compared with 2015 to 788.3 billion rubles.

Opex Structure Analysis

Indicator

2016

Share in Total Expenses

2015

Share in Total Expenses

YoY Change

bn RUB bn RUB

Uncontrollable expenses, including 524.4 66.5% 407.0 62.4% 28.8%

Electricity transmission and distribution services

131.0 16.6% 119.3 18.3% 9.8%

Electricity purchased for compensation for electricity network losses

111.5 14.1% 101.2 15.5% 10.2%

Electricity purchased for resale 46.0 5.8% 31.2 4.8% 47.4%

Depreciation and amortization 113.8 14.4% 100.5 15.4% 13.2%

Taxes and levies except profit tax 20.8 2.6% 17.6 2.7% 18.2%

Impairment of fixed assets 38.5 4.9% -5.1 -0.8%

Impairment of receivables 19.6 2.5% 28.8 4.4% -31.9%

Provisions 9.6 1.2% 3.9 0.6% 146.2%

Other 33.6 4.3% 9.6 1.5% 250.1%

Controllable expenses, including 263.9 33.5% 245.5 37.6% 7.5%

Employee benefits 173.6 22.0% 162.9 25.0% 6.6%

Other 90.3 11.5% 82.6 12.7% 9.3%

Total operating expenses 788.3 652.5 20.8%

Total operating expenses less impairment of fixed assets and receivables

730.2 628.8 16.1%

4 More detailed information is contained in Section 4.4 “Results of Investing Activities” of the Annual Report

10

The Group’s uncontrollable expenses increased by 117.4 billion rubles in 2016 (↑ 28.8%) due to the following factors

■ Electricity distribution services grew by 11.7 billion rubles (↑ 9.8%) due to higher service prices charged by certain territorial grid organizations.

■ Expenses associated with electricity purchased for compensation for electricity network losses increased by 10.3 billion rubles (↑ 10.2%) due to higher prices of purchased electricity.

■ Expenses associated with electricity purchased for resale increased by 14.8 billion rubles (↑ 47.4%) due to changes in the operating mode of the electric grid and due to higher electricity sales.

■ Depreciation and amortization grew by 13.3 billion rubles (↑ 13.2%) due to putting into operation new fixed assets under the capex program.

■ Tax payments increased by 3.2 billion rubles (↑ 18.2%) in the reporting period due to gradually abolished property tax benefits in relation to electric grid facilities.

■ Impairment of fixed assets in the amount of 38.5 billion rubles was recognized due to a reduction in estimated future cash flows from using grids.

■ Provisions increased by 5.7 billion rubles due to the recognition of contingent liabilities in connection with litigation with outside territorial grid organizations in relation to electricity distribution and with electricity retailers in relation to electricity purchased for compensation for electricity network losses.

■ Other expenses increased by 24.0 billion rubles mainly due to expenses associated with subcontractor services and because of tangible costs related to construction contracts and due to a rise in fuel expenses for mobile and gas turbine plants.

The Group’s controllable expenses grew by 18.4 billion rubles in 2016 (↑ 7.5%) because of an increase of 10.7 billion rubles (↑ 6.6%) in employee benefits due to wage indexation for production personnel in accordance with the Sectoral Wage Rate Agreement.

Net Other Income

Net other income grew by 25.8% to 27.8 billion rubles largely due to a rise in income from penalties and late payment interest under commercial contracts and an increase in income from identified noncontractual consumption of electricity.

EBITDA

EBITDA was 265.2 billion rubles, while adjusted EBITDA reached 323.3 billion rubles. The key factors contributing to the upward changes were the implementation of measures under the Program to Improve the Operating Efficiency and Reduce Expenses of the ROSSETI Group, decreased impairment of the Group’s receivables, and increased revenue from network connection services.

The adjusted EBITDA margin reached 35.8% (0.2 percentage point higher than in 2015).

EBITDA Analysis

Indicator, mn RUB 2016 2015 % vs. 2015

Profit for the period 98,341 81,602 20.5

Depreciation and amortization 113,766 100,529 13.2

Interest paid under financial obligations with amortized cost 31,494 34,607 (9.0)

Interest paid under finance lease obligations 130 94 38.3

Profit tax expense 21,501 32,110 (33.0)

11


EBITDA 265,232 248,942 6.5

Adjusted EBITDA 323,322 273,080 18.4

Adjusted EBITDA margin 35.8% 35.6% 0.2 pp

Assets

The book value of the ROSSETI Group’s assets as at December 31, 2016, stood at 2,266.7 billion rubles, or 5.6% higher than in 2015.

Non-current assets increased by 8.2% to 1,960 billion rubles. Changes in increased non-current assets were caused by a rise in the value of fixed assets due to the commissioning of capital assets under the capital investment program.

Non-current receivables went up by 34.7 billion rubles to 51.3 billion rubles mainly due to a rise in receivables under network connection contracts with payment in installments.

The value of long-term financial assets increased by 53.4 billion rubles due to a rise in the Inter RAO share price.

Structure of Non-Current Assets


Fixed assets 1,798,568 1,734,044 3.7

Intangible assets 16,804 18,532 (9.3)

Investments in associates and joint ventures 936 1,489 (37.1)

Non-current receivables 51,262 16,572 209.3

Other investments and financial assets 85,351 31,928 167.3

Deferred tax assets 7,069 8,579 (17.6)

TOTAL NON-CURRENT ASSETS 1,959,990 1,811,144 8.2

Current assets decreased by 8.3% to 306.7 billion rubles in 2016. Changes in cash and cash equivalents and in other investments and financial assets (mainly bank deposits with a maturity of more than three months) were caused by the fact that the proceeds from bonds placed in 2015 were used in 2016 and that the proceeds from additionally issued shares (including special-purpose funds (LENENERGO) were used to finance network connection activities. Receivables grew largely due to increased revenue.

12

Structure of Current Assets


Inventories 33,143 33,921 (2.3)

Other investments and financial assets 12,620 36,777 (65.7)

Income tax prepayments 6,339 4,201 50.9

Trade and other receivables 167,616 162,624 3.1

Cash and cash equivalents 86,970 97,090 (10.4)

TOTAL CURRENT ASSETS 306,688 334,613 (8.3)

Key Financial Ratios

INDICATOR 2014 2015 2016

Adjusted EBITDA margin 32.8% 35.6% 35.8%

Operating expenses/revenue 100.0% 85.1% 87.2%

Net debt/adjusted EBITDA 2.0 1.8 1.5

Current ratio 0.75 0.84 0.83

Financial leverage 0.91 0.84 0.74

Long-term loans/gross debt 84% 80% 84%

Debt Capital

Information on Obtained Loans and Borrowings

The main priorities of the ROSSETI Group’s financial policy are to obtain the resources necessary for uninterrupted financing for the Group’s entities, maintain financial stability, and gain wider appeal among investors. All these objectives were successfully achieved in 2016.

The Group’s debt portfolio consists mostly of bonds and loans issued by government-linked banks. 100% of the Group’s loans and borrowings are denominated in Russian rubles.

The Group maintains strategic partner relations with major Russian banks such as Sberbank, Gazprombank, and VTB Bank. At the same time, the Group’s entities are open to cooperation in debt financing with credit institutions that are ready to offer attractive conditions.

13

Debt Breakdown5

The Group’s debt portfolio decreased from 584 to 559 billion rubles in 2016.

bn RUB

Type of borrowing

December 31, 2015 December 31, 2016 Total Debt

Growth

Total Principal

debt

Accrued

interest Total

Principal

debt

Accrued

interest bn RUB %

Bond loans 344 337 7 326 321 5 -18 -

5%

Bank loans and other

lenders 240 239 1 233 231 2 -7

-

3%

TOTAL 584 576 8 559 552 7 -25 -

4%

Note: Other lenders include liabilities related to finance leases, bills and notes, and other loans.

The Group took full advantage of the better situation in the financial markets and earlier refinanced a considerable share of the debt portfolio under more attractive terms and conditions.

The average interest rate for the Group’s debt portfolio decreased from 11.5% to 8.9% p.a. in the reporting year. Debt service expenses decreased by 8.3 billion rubles in 2016 compared with 2015 (including capitalized interest).

% p.a.

Type of borrowing

Weighted Average Interest Rates Interest Rate Growth

January 1, 2016 January 1, 2017 pp

Bank loans 9.9% 9.8% -0.1%

Bond loans 12.6% 8.3% -4.3%

TOTAL 11.5% 8.9% -2.6%

5 Principal debt less accrued but unpaid interest

134

32

5213

321

Сбербанк

ВТБ

ГПБ

прочие кредиторы

Облигационные займы

bn RUB

Sberbank

VTB Bank

Gazprombank

Other lenders

Bond loans

14

Most loans and borrowings in the debt portfolio are long-term debt, which allows the Group to have a convenient repayment schedule.

Debt Repayment Schedule6

Information on Issued and Redeemed Bonds

ROSSETI placed two 10-year bond issues to Vnesheconombank in 2016 with a total par value of 10 billion rubles.

Main Characteristics of Bond Issues Placed by ROSSETI in 2016

Issue Number Series Value of Outstanding

Bonds, mn RUB Placement Date

Interest Rate at Placement, %

ROSSETI

4B02-02-55385-E BO-02 5,000 August 30, 2016 9.15%

4B02-03-55385-E BO-03 5,000 August 30, 2016 9.15%

The bonds were issued to refinance the loan portfolio of ROSSETI’s subsidiaries.

In November 2016, the MICEX Stock Exchange registered the ROSSETI Program of Series 001P Exchange-Traded Bonds.7 The Program provides for the placement of exchange-traded bonds with a total par value of up to 100.0 billion rubles, with each issue under the Program having a 30-year maximum term to maturity.

In December 2016, ROSSETI repaid earlier all Series BO-04 exchange-traded bonds totaling 10.0 billion rubles and placed on June 8, 2015 (with a coupon rate of 11.85%).

ROSSETI’s subsidiaries raised a total of 39.35 billion rubles in bonds in 2016, including 10 billion rubles coming from intragroup financing.

6 Principal debt less accrued but unpaid interest. 7 Program identification number: 4-55385-Е-001Р-02Е.

17 22 18 24

13199

242

0

50

100

150

1кв2017 2кв2017 3кв2017 4кв2017 2018 2019 после 2019

bn RUB

1Q2017 2Q2017 3Q2017 4Q2017 after 20192018 2019

15

Issue Number Series Value of Outstanding

Bonds, mn RUB Placement Date

Interest Rate at Placement, %

IDGC of Urals

4B02-05-32501-D BO-05 5,000 August 26, 2016 9.32%

IDGC of Centre

4B02-05-10214-A BO-05 5,000 August 26, 2016 9.32%

IDGC of Northern Caucasus

4B02-01-34747-E-001P BO-001P-01 1,350 April 28, 2016 13.00%

MOESK

4B02-08-65116-D BO-08 8,000 April 28, 2016 10.30%

4B02-05-65116-D BO-05 5,000 June 7, 2016 10.00%

4B02-06-65116-D BO-06 5,000 July 28, 2016 9.65%

FGC UES

4B02-02-65018-D BO-02 10,000 November 29, 2016 9.35%

The ROSSETI Group’s principal investors in 2016 were management companies, pension funds, and large banks.

The following subsidiaries of ROSSETI obtained registration for their programs of exchange-traded bonds

Subsidiary Identification

Number

Identification Number

Assignment Date Value

Maximum Term to Maturity Under the Program

Kubanenergo 4-00063-A-002P-

02E October 24, 2016

up to 25 billion rubles

30 years

IDGC of Northern Caucasus

4-34747-E-002P-02E

September 23, 2016 up to 25 billion

rubles 30 years

IDGC of North-West 4-03347-D-001P-

02E November 11, 2016


30 years

IDGC of Siberia8 4-12044-F-001P-

02E September 7, 2015


30 years

IDGC of Centre 4-10214-A-001P-

02E December 21, 2016


30 years

IDGC of Center and Volga Region

4-12665-E-001P-02E

October 10, 2016 up to 25 billion

rubles 30 years

8 Registration for amendments to the Program

16

IDGC of South 4-34956-E-001P-

02E August 12, 2016


30 years

Events After the Reporting Period

■ On February 8, 2017, the Moscow Exchange assigned identification numbers to the MOESK Program of Series 001P Exchange-Traded Bonds totaling 80 billion rubles and the IDGC of Urals Program of Series 001P Exchange-Traded Bonds totaling 25 billion rubles, with each issue under the Programs having a 30-year maximum term to maturity.

■ On March 1, 2017, the Moscow Exchange assigned an identification number to the Tyumenenergo Program of Series 001P Exchange-Traded Bonds totaling 25 billion rubles, with each issue under the Program having a 30-year maximum term to maturity.

■ On March 17, 2017, the Moscow Exchange assigned an identification number to the IDGC of Volga Program of Series 001P Exchange-Traded Bonds totaling 25 billion rubles, with each issue under the Program having a 30-year maximum term to maturity.

■ On April 5, 2017, the Moscow Exchange assigned an identification number to the LENENERGO Program of Series 001P Exchange-Traded Bonds totaling 35 billion rubles, with each issue under the Program having a 30-year maximum term to maturity.

Credit Rating History (Timeline); Parameters and Factors Determining the Current Ratings

The ROSSETI Group is active in cooperating with leading international rating agencies: Moody’s, Standard & Poor’s, and Fitch Ratings. In accordance with the methodologies of the international rating agencies, ROSSETI and its SDCs qualify as government-linked companies. Consequently, the credit ratings of the Group’s entities are closely tied to the sovereign rating of the Russian Federation.

Against a background of stabilization in the Russian economy in 2016, the international rating agencies partially reconsidered their previous negative decisions concerning the sovereign rating of the Russian Federation, which enabled the agencies to take positive rating actions on the ROSSETI Group’s entities:

■ in March 2016, the sovereign rating of the Russian Federation and the credit ratings of some Russian

companies were place by Moody’s on the Watchlist with a negative outlook. However, as early as

April, the Russian sovereign rating was removed from the Watchlist, which also reaffirmed the

Group’s creditworthiness ratings;

■ in October 2016, following an upgraded rating outlook for the Russian Federation, Fitch Ratings

changed FGC UES’s rating outlook from negative to stable and reaffirmed the rating at the sovereign

level of BBB–.

ROSSETI’s international credit rating from Standard & Poor’s corresponds to the sovereign rating

The credit ratings received by ROSSETI and FGC UES from Standard & Poor’s correspond to the ratings of the Russian Federation and follow their trends. For instance, as with the sovereign rating, both companies’ rating outlooks were upgraded to stable in September 2016.

Receiving credit ratings from international credit rating agencies enables ROSSETI and its subsidiaries to be increasingly attractive to investors and pursue an effective borrowing policy in public capital markets.

Events After the Reporting Period

In February 2017, Moody’s upgraded FGC UES’s rating outlook to stable due to an upgraded outlook for the sovereign rating of the Russian Federation.

17

In March 2017, Standard & Poor’s upgraded the outlooks for the credit ratings of ROSSETI, FGC UES, MOESK, and IDGC of Centre to positive after the rating of the Russian Federation was revised. Additionally, the agency decided to upgrade ROSSETI’s own creditworthiness by one notch to BB due to the Company’s high operating performance.

ROSSETI Group Credit Ratings as of December 31, 2016

Company

Credit rating

Initial assignment date

MOODY’S¹ S&P FITCH¹

ROSSETI Ba2 BB+

ruAA+ - July 2010/March 2014

FGC UES Ba1 BB+

ruAA+ BBB-

February 2006

June 2004 October

2013

MOESK Ba2 BB-

ruAA- BB+

October 2007

January 2012

August 2013

IDGC of Centre - BB-

ruAA- - November 2009

IDGC of Volga Ba2 - - October 2012

IDGC of Center and Volga Region

Ba2 - - October 2012

IDGC of Urals Ba2 - - October 2012

LENENERGO Ba2 - - November 2009

¹ National scale rating withdrawn

18

5. ROSSETI Shareholding Structure and Share Market

Information on the Company’s Securities

Shares

The share capital of ROSSETI is one hundred sixty-three billion, one hundred fifty-four million, two thousand, six hundred ninety-four (163,154,002,694) rubles and consists of one hundred sixty-three billion, one hundred fifty-four million, two thousand, six hundred ninety-four (163,154,002,694) shares, each with a par value of 1 ruble, including one hundred sixty-one billion, seventy-eight million, eight hundred fifty-three thousand, three hundred ten (161,078,853,310) ordinary shares and two billion, seventy-five million, one hundred forty-nine, three hundred eighty-four (2,075,149,384) preference shares.

Quantity of Federally Owned Shares in ROSSETI as of December 31, 2016

Shareholder

Quantity of Shares Percentage of Share

Capital,9 % Ordinary Shares Preference Shares

Federal Agency for State Property Management

175,563,402,640 145,523,224 87.90

Principal Shareholders with a Share of More than 2% as of December 31, 2016

Shareholders Percentage of Share Capital, %

The Russian Federation represented by the Federal Agency for State Property Management

87.90

National Settlement Depository (nominee shareholder) 8.75

Depository and Corporate Technologies (nominee shareholder) 2.73

TOTAL: 98.86

The Company’s shares are currently included in the following stock market indices:

Index Weight, % Index Currency

MICEX Index 0.24 OS RUB

MICEX Power Index

9.58 OS RUB

1.66 PS RUB

MICEX SMID Index 1.68 OS RUB

Second-Tier Index 2.12 PS RUB

RTS Index 0.24 OS USD

9 The percentage specified includes actually placed shares of the Company's current issue.

19

State-Owned Companies Index 1.28 OS RUB

Moscow Exchange Broad Market Index

0.23 OS RUB

0.04 PS RUB

RTS SMID Index 1.77 OS USD

Key Indicators of Trading in the Company’s Shares for 2015 and 2016

Indicator Unit 2015 2016 Change, %

Trading volume

Ordinary shares

billion RUB

18.48 65.64 255.2%

Preference shares 0.70 1.78 154.8%

Ordinary shares

billion shares

36.74 79.46 116.3%


Number of deals

Ordinary shares million shares

0.77 2.27 194.2%


Maximum price

Ordinary shares

RUB

0.67 1.34 100.6%


Minimum price

Ordinary shares

RUB

0.40 0.43 6.7%


Weighted average price at year end

Ordinary shares RUB

0.46 1.143 148.5%


Capitalization at year end* million RUB 91,084.916 228,600.727

* Including additionally issued outstanding shares

20

6. Corporate Governance

ROSSETI views governance as an integral and inseparable part of the sustainability strategy and as a means of improving the efficiency of its operations, building up its reputation, and making the Company more attractive to investors.

ROSSETI ’s governance system is in accordance with the Russian applicable laws, the Articles of the Association and internal documents of the Company, and the Company’s obligations associated with the trading of securities in global stock markets. ROSSETI also applies global best practices in governance.

Principal goals and objectives of the Company’s governance:

■ ensure the unconditional, timely, and complete exercise of the legitimate rights and interests of all shareholders;

■ develop efficient interaction between the Company and its SDCs to develop and improve the reliability of the electric grid sector and increase the market value;

■ enhance the transparency of decisions made by management bodies, maximize the disclosure of information about the Company’s activities, and improve the governance system of ROSSETI;

■ constantly improve the mechanisms for relations between the Company and shareholders, securities holders, and potential investors with due consideration to the Company’s obligations to third parties;

■ improve the existing forms and methods and develop new forms and methods for maintaining relations with shareholders to facilitate the exercise of their rights, and develop advanced means of communication for shareholder relations.

ROSSETI guarantees that its shareholders will exercise all of their rights provided by Russian laws, the Articles of Association, and internal documents of the Company.

Members of the Board of Directors of ROSSETI after June 30, 2016

Name Year of Birth Position10

Alexander Valentinovich Novak 1971 Chairman, Russian National Committee of the World Energy Council

Stanislav Olegovich Ashirov independent director

1973 Deputy Director General for Strategic Development (part-time), Tyumen Power Sales Company; Director General, Mezhregionenergosbyt

Boris Ilyich Ayuyev 1957 Chairman of the Management Board, SO UPS

Oleg Gennadyevich Barkin 1975 Deputy Chairman of the Board, NP Market Council

Vasily Mikhailovich Belov independent director

1981

Senior Vice-President for Innovations, Non-Profit Organization the Fund for Development of the Center for Elaboration and Commercialization of New Technologies

Oleg Mikhailovich Budargin 1960 Director General and Chairman of the Management Board, ROSSETI

Oleg Markovich Dubnov independent director

1971 Advisor to the Director General, Institute of Professional Directors

Alexander Sergeyevich Kalinin independent director

1966 President, OPORA RUSSIA; President, OPORA Nonprofit Partnership

Vyacheslav Mikhailovich Kravchenko

1967 Deputy Minister of Energy of the Russian Federation

10 The positions specified are as of the time of election.

21

Andrey Yevgenyevich Murov 1970 Chairman of the Management Board and member of the Board of Directors, FGC UES

Nikolay Radyevich Podguzov 1974 Deputy Minister of Economic Development of the Russian Federation

Mikhail Igorevich Poluboyarinov 1966 First Deputy Chairman and member of the Board, Vnesheconombank

Nikolay Dmitryevich Rogalev 1962 Rector, Department Head, and Professor, Moscow Power Engineering Institute (National Research University)

Sergey Ivanovich Shmatko 1966 Special Representative of the President of the Russian Federation on International Cooperation in the Electric Power Industry

Nikolay Grigoryevich Shulginov 1951 Chairman of the Management Board and General Director, RusHydro

Members of the Board of Directors of ROSSETI until June 30, 2016

Name Year of Birth Position11

Alexander Valentinovich Novak 1971 Chairman of the Board of Directors of ROSSETI; Minister of Energy of the Russian Federation

Stanislav Olegovich Ashirov 1973 Director General, Mezhregionenergosbyt

Boris Ilyich Ayuyev 1957 Chairman of the Management Board, SO UPS

Oleg Gennadyevich Barkin 1975 Deputy Chairman of the Board, NP Market Council

Vasily Mikhailovich Belov 1981 Senior Vice-President for Innovations, Non-Profit Organization the Fund for Development of the Center for Elaboration and Commercialization of New Technologies

Oleg Mikhailovich Budargin 1960 Director General, ROSSETI

Anatoly Fyodorovich Dyakov12 1936 President and Chairman of the Scientific and Technical Board, Scientific and Technical Council of Unified Energy System

Andrey Yurievich Ivanov 1975 Deputy Minister of Finance of the Russian Federation

Alexander Sergeyevich Kalinin independent director

1966 President, OPORA RUSSIA All-Russian Public Organization of Small and Medium Business

Alexei Aleksandrovich Makarov independent director

1937 Member of the Presidium, Russian Academy of Sciences

Denis Stanislavovich Morozov 1973 Representative of the Russian Federation on the Board of Directors of the European Bank for Reconstruction and Development

Andrey Yevgenyevich Murov 1970 Chairman of the Management Board, FGC UES

Oleg Romanovich Fyodorov 1968 Member of the Supervisory Board, ALROSA

11 The positions specified are as of the time of election. 12 Member of the Board of Directors of ROSSETI A. F. Dyakov died on August 12, 2015.

22

Andrey Nikolayevich Shishkin 1959 Vice President for Energy and Localization, Rosneft

Sergey Ivanovich Shmatko 1966 Special Representative of the President of the Russian Federation on International Cooperation in the Electric Power Industry

Remuneration for Members of the Board of Directors

Remuneration is paid to the members of the Board of Directors in accordance with the Regulations for Remuneration and Compensation for Members of the Board of Directors.

Remuneration is paid in the amount calculated by the formula specified in the Regulations and taking account of the total number of meetings of the Board of Directors in the previous corporate year and taking account of the number of meetings in which each member of the Board of Directors takes part.

The remuneration base amount is based on the revenues calculated in accordance with Russian Accounting Standards and received by the Company in the financial year.

On top of the remuneration, the following premiums apply:

■ 30% payable to the Chairman of the Board of Directors;

■ 20% payable to the chairman of a specialized committee of the Board of Directors;

■ 10% payable to a member of a specialized committee of the Board of Directors.

No remuneration is paid to:

■ executive directors;

■ persons who are subject to a statutory restriction or ban on payments from for-profit organizations;

■ members of the Board of Directors if they participate in less than 50% of meetings.

Any member of the Board of Directors may decline to receive the remuneration provided for in the Regulations, in full or in part, by notice thereof to the sole executive body (Director General).

No remuneration was accrued and paid to the members of the Board of Directors in 2016 due to the absence of the Company’s net profit.

Remuneration for Members of the Management Board and the Sole Executive Body

The motivation system for ROSSETI’s senior managers is aimed at incentivizing them to achieve the strategic goals and increase the economic effectiveness of management. The procedures for determining and paying remuneration is are governed by the Regulations for Financial Incentives for Senior Managers and include the fixed and variable parts of pay.

The variable part of remuneration depends on attained key performance indicators (KPIs). The composition, calculation techniques, and target values of KPIs are approved by the Board of Directors of ROSSETI according to the goals of the Strategy for Development of the Electric Grid Sector of the Russian Federation and the Long-Term Development Program of the Company.

Type of Remuneration Amount of Remuneration,

million rubles

Remuneration for participation in the work of the management body/financial and economic control body

4.70

Salary 108.53

Bonuses 169.60

Commission fees 0

23

Benefits 0

Other remuneration 1.68

TOTAL 284.51

Information on Shareholdings

Members of the Board of Directors holding a stake in the issuer’s authorized capital on or before June 30, 2016

Boris Ilyich Ayuyev

Member of the Board of Directors

Date of reelection to the Board of Directors of ROSSETI: June 30, 2016

Position as of the time of election: Chairman of the Management Board, SO UPS

Stake held by the individual in the authorized capital of the issuer, %: 0.004531

Percentage of ordinary shares held by the individual in the issuer, %: 0.004579

Anatoly Fyodorovich Dyakov


Date of election to the Board of Directors of ROSSETI: June 30, 2015. Not reelected on June 30, 2016

Position as of the time of election: President and Chairman of the Scientific and Technical Board, Scientific and Technical Council of Unified Energy System

Stake held by the individual in the authorized capital of the issuer, %: 0.0031

Percentage of ordinary shares held by the individual in the issuer, %: 0.00314

Oleg Mikhailovich Budargin


Date of election to the Board of Directors of ROSSETI: June 30, 2016

Position as of the time of election: Director General, ROSSETI

Stake held by the individual in the authorized capital of the issuer (as of December 31, 2017),%: 0.000569

Percentage of ordinary shares held by the individual in the issuer (as of December 31, 2017), %: 0.00576

24

Liability Insurance

ROSSETI takes out liability insurance for directors and officers (including members of the Board of Directors, members of the Management Board, and independent directors) to indemnify the Company’s shareholders, creditors, and other persons for their damage (losses) caused by the mistakes and unintentional acts (omission to act) on the part of such directors and officers while they perform their managerial activities.

The term of the insurance contract is from December 25, 2016, to July 24, 2018. The insurance premium under the insurance contract is 22.4 million rubles, while the total insured amount (aggregate limit of liability) is 10 billion rubles. The liability insurance contract provides directors and officers with coverage consistent with international insurance standards as to insured risks and indemnity limits.

Internal Control System

The internal control system (ICS) assures not only safe business development but also the stable functioning of social systems, which is of particular importance to the electric power industry.

The ROSSETI Group set up and develops the ICS to achieve the following goals:

■ ensure efficiency and productivity of organizing the Company’s and its SDCs’ activities; safeguard

assets;

■ ensure compliance with the applicable legal requirements and local regulatory documents, including

in economic events and business accounting;

■ ensure the reliability and timeliness of accounting (financial) and other reporting.

The effectiveness of the ICS relies on the interrelationship of the following constituent management processes:

■ Organization of effective internal control over business processes;

■ Risk management;

■ Internal audit and independent evaluation;

■ Auditorial control.

In 2016, ROSSETI was recognized by the National Union of Internal Auditors and Controllers as a winner of the national award “Effective Internal Control and Audit of the Year” in the category “Best Company in Internal Control System Reliability.”

The Company will continue its efforts in 2017 to ensure the stable functioning and reliability of the ROSSETI Group’s internal control system.

The Company takes a unified approach to organizing its internal control system.

25

Roles of ICS Participants

Participant in the Internal Control System

Principal Functions in the Internal Control System Principal Internal Documents Specifying the Functions

Internal Audit Commission

■ Exercise control of financial and economic activities

■ Prepare proposals/recommendations to improve the internal control system

■ Make an independent assessment of the reliability of information contained in the annual report and annual accounting statements

Articles of Association, Internal Control Policy, Regulations for the Internal Audit Commission

Board of Directors

■ Approve internal documents defining the organization and the development and improvement strategy of the internal control system

■ Approve the Internal Control Policy containing the principles of and approaches to the organization of the internal control system

■ Control the activities of executive bodies in the principal (high-priority) areas

Articles of Association, Internal Control Policy

26

■ Review the results of the evaluation of internal control system effectiveness on an annual basis

Audit Committee of the Board of Directors

■ Carry out a preliminary review of internal documents defining the organization and the development and improvement strategy of the internal control system, the Internal Control Policy, and subsequent amendments thereto

■ Carry out a preliminary review of the results of the evaluation of internal control system effectiveness based on the internal auditor’s report on internal control system effectiveness and based on reports on the findings of external independent evaluation and prepare proposals and recommendations to improve the internal control system

■ Oversee the reliability and effectiveness of the internal control system as related to supervising the reliability of accounting (financial) statements, selecting the external auditor and conducting the external audit, and ensuring compliance with regulatory and legal requirements and as related to analyzing and assessing the implementation of the Internal Control Policy

Internal Control Policy, Regulations for the Audit Committee

Other committees of the Board of Directors

Oversee the attainment of prescribed financial and operational indicators, compliance with the applicable laws, compliance with the rules and procedures set forth in local regulatory documents, and the reliability and timeliness of reporting within their competence specified by the Board of Directors

Internal Control Policy, committee regulations

Executive bodies

Ensure the effective internal control system is created and kept in working order, including:

■ defining the areas and plans of developing and improving the internal control system

■ approving regulatory and methodological documents relating to the organization and functioning of the internal control system within their competence

■ ensuring the implementation of action plans

■ preparing and submitting for consideration by the Board of Directors reports on financial and economic activities and on the organization, functioning, and effectiveness of the risk management and internal control systems

Articles of Association, Internal Control Policy, Procedure for Implementing the Internal Control Policy

Divisions

■ Implement the principles of the internal control system

■ Organize and regulate the building of effective processes (areas of activities), including using identified risks to develop and implement new control procedures or change existing control procedures

■ Carry out control procedures

■ Perform self-assessment in relation to supervised processes (areas of activities) and initiate the improvement of control procedures

■ Correct discovered deficiencies in control procedures and processes (areas of activities)

Internal Control Policy, Procedure for Implementing the Internal Control Policy, division regulations

Internal control division

■ Develop basic and methodological documents and ensure their implementation in relation to building up and improving the internal control system

■ Assist management in building the control environment and formulate recommendations for the description of

Internal Control Policy, Procedure for Implementing the Internal Control Policy, regulations for the internal control division

27

control procedures and their introduction into processes (areas of activities) and for the assignment of responsibilities to officers

■ Coordinate measures to maintain and monitor the intended state of the internal control system

■ Prepare information on the state of the internal control system for stakeholders

Internal audit division

■ Prepare recommendations based on the internal audit results to improve control procedures, specific components (elements) of internal control and the internal control system

■ Make the internal evaluation of internal control system effectiveness and provide recommendations to improve the efficiency and effectiveness of the internal control system

Internal Control Policy, Procedure for Implementing the Internal Control Policy, Internal Audit Policy, regulations for the internal audit division

Key measures to improve the internal control system:

The internal independent evaluation of internal control system effectiveness is made by the internal audit division on an annual basis.

As noted by the Audit Committee of the Board of Directors of ROSSETI, there were improvements in the development (maturity) level of internal control in 2015, and the current maturity was found to be in conformity with the Moderate level (in accordance with the criteria established by the Strategy).

The external independent evaluation of internal control system effectiveness is made by external independent consultants at least every three years, depending on changes in the organizational activities and on the general level of the internal control system’s development, reliability, and effectiveness. The external independent evaluation of the ROSSETI Group’s internal control system in 2016 was not made.

The ROSSETI Group carried out the following key measures in 2016 to improve the internal control system:

■ The Procedure for Implementing the Requirements of the Internal Control Policy was formulated and

introduced into the Company and SDCs.

■ ROSSETI’s electricity sector management processes were analyzed, and the related control

procedures were documented.

■ ROSSETI constructed standard matrixes for controls for SDCs’ core business processes and

introduced them into SDCs.

■ Management processes and auxiliary processes of SDCs’ operating activities were analyzed, and

standard matrixes for controls were constructed.

■ The internal audit functions of ROSSETI SDCs were made separate divisions functionally

subordinate to SDCs’ boards of directors and administratively subordinate to their sole executive

bodies.

Key objectives for 2017:

■ further the development of internal control in management processes;

■ further the integration of the internal control and risk management systems;

■ document the authority and responsibilities of managers of business units and functional areas in

responsibility matrixes;

■ improve the competencies of suppliers of internal control assurances and approve the assurance

map.

28

7. Risk Management

PJSC ROSSETI’s performance is affected by risks determined by a number of external factors. Risks are mostly due to macroeconomic factors impacting the Russian economy and certain areas of the Company’s activities.

The list of such risks provided below is incomplete since there are other risk which are currently not significant, but may have an adverse impact on the Company’s activities if the probability of their occurrence and the level of their significance become higher.

Industry-Specific Risks

Since PJSC ROSSETI does not perform any direct operating activities and only carries out corporate management of its subsidiaries and dependent companies (SDCs), the industry-specific risks described below are primarily associated with the Company’s SDCs.

Tariff risks

The core activities of the Company’s SDCs, the provision of electricity distribution and transmission services and network connection services, are subject to regulation by the government. Taking account of these special features of PJSC ROSSETI’s operations, the Company’s industry-specific risks affecting the strategic priorities of PJSC ROSSETI’s development include risks associated with tariff regulation. The government’s tariff regulation policy provides for a change in grid organizations’ regulated tariffs in 2016–2018 for the index lower than actual inflation, which leads to the risk that regulatory authorities may impose a pool of tariffs that would not make it possible to take into account economically feasible revenues.

The risk that regulatory authorities may set tariffs lower than an economically feasible level arises out of the following factors:

■ economically feasible expenses incurred by grid companies are not taken into account in full in the course of approving tariffs;

■ dividend payment expenses in accordance with directives of the Government of the Russian Federation, actual loan debt service expenses, etc. are not recognized as economically feasible;

■ a mechanism for redistributing minimum regulated revenue is applied to smooth out tariffs;

■ the ceiling value of cross-subsidies established by the Government of the Russian Federation is limited without due consideration to the objective factors of its growth;

■ compared with the indexation of grid tariffs, grid organizations pay more for electricity network losses as a result of an outstripping growth in prices in the wholesale electricity market;

■ network connection services are subject to existing and new preferential terms while connection costs are on the rise.

Another tariff risk is that the actual indicators of electricity and capacity consumption are different from the indicators taken into account in the course of making tariff and balancing decisions, including as a result of changes in consumption patterns.

These tariff risks result in a shortfall in tariff revenues received by SDCs from the regulated activities.

Risk management related to tariff regulation is carried out in the following areas:

■ interaction with executive authorities of constituent entities of the Russian Federation in government regulation of tariffs in course of designing economically feasible tariffs;

■ interaction with federal executive authorities (the Federal Antimonopoly Service, the Ministry of Energy, the Ministry of Economic Development, etc.) in order to systematically improve the principles of tariff regulation;

■ appeals filed against regional regulators’ decisions by applying the pre-trial resolution of disagreements and by having resort to court proceedings.

29

The Company also cooperates with federal executive authorities in introducing changes to legislation in relation to the fair distribution of cross-subsidies among all customers, the elimination of grid companies’ lost income resulting from the termination of last mile agreements, and the practical application of agreements for regulated activities with regional tariff regulators to hold territorial grid organizations’ lost income resulting from interrupted electricity consumption at a fixed level and define a mechanism for settling such lost income.

In addition, to minimize these factors, the Company and SDCs pursue 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.

Risk associated with the decreased volume of electricity distribution services

The risk associated with the decreased volume of electricity distribution services and affecting the strategic priorities of the Company’s development is due to the following factors:

■ Overall decline in electricity demand

The principal reason is Russia’s contracting investment activity and adverse changes in market conditions, chiefly in

the hydrocarbons and metals markets, amid international sanctions. Statistics show the continuing decline in industrial

production in the Russian Federation.

■ External electricity supply optimized by customers decreasing electricity consumption from Russia’s United

Power System (Unified National (All-Russian) Electric Grid) and making increasingly wide use of in-house

generation facilities.

The negative factors affecting Russia’s socioeconomic activities were a fall in real household income, a higher level of

inflation, a rise in production costs, etc. In order to minimize this risk, the Company and SDCs carry out measures to

enhance the reliability of the predicted volume of electricity distribution services for pricing and business planning

purposes.

Risks associated with the provision of network connection services for requesting entities affect three aspects: a possible shortage of financing sources for measures to perform contracts, the nonperformance of a network connection contract by a requesting entity, and a requesting entity’s failure to utilize the capacity provided.

The principal risk associated with the provision of network connection services is the risk that financing sources may be insufficient for measures to perform network connection contracts.

Factors contributing to this risk are associated with preferential terms provided for customers and with amendments to Russian laws in relation to network connection fees for power-receiving equipment rated below 150 kW.

To minimize the risk, the Company takes the following measures:

■ formulating and submitting documents to tariff regulation authorities to justify lost income from network connection services and the economic feasibility of network connection fee rates;

■ optimizing technical solutions as part of the preparation of technical specifications for network connection.

The Group also improves approaches to organizing the business process related to the performance of electricity network connection services and works on amendments to legal regulations to set economically feasible network connection fee rates.

The second most important risk is the risk that a requesting entity may fail to perform obligations under network connection contract, including the refusal of connection. This leads to the no utilization of commissioned equipment and to lost profits from electricity distribution services.

30

In order to mitigate this risk, SDCs cooperate with requesting entities, including explaining the necessity of performing obligations under network connection contracts, together with the implications of their nonperformance (penalties, extended deadlines), and file claims against requesting entities for grid organizations’ damages in relation to abandoned network connections, including damages payable to superior grid organizations.

The risk that a requesting entity may fail to utilize the capacity provided is associated with newly connected customers’ failure to comply with such planned parameters of provided and accepted loads as specified in network connection requests.

To mitigate the risk, the Company monitors the maximum capacity specified in network connection requests, cooperates with regulatory authorities in preparing the schemes and development programs for the electric power industry of constituent entities of the Russian Federation, and informs requesting entities of main substations’ available capacity in the relevant region, including explaining the procedure that should be followed if any requesting entity is interested in being connected to underutilized substations.

Risk associated with the failure of customers to pay for provided electricity distribution services (contested and uncontested overdue receivables).

This risk arises from imperfect operation mechanisms of the retail electricity market and from the insufficiency of existing mechanisms for encouraging customers to make timely payments for electricity distribution services and also results from macroeconomic factors.

This entails disagreements between electric grid companies and retail companies over the volume of consumed electricity and capacity. This leads to overdue receivables related to electricity distribution services provided by SDCs, impairing the liquidity and financial stability of the Company’s SDCs.

The Company and SDCs take measures to eliminate the causes of disagreements, reduce contested overdue receivables for their services provided, cooperate with federal governmental authorities 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 implement the Long-Term Development Programs for Electricity Metering Systems in the Retail Electricity Market in Distribution Grids of PJSC ROSSETI’s SDCs approved by their boards of directors.

A significant factor influencing the level of payment for provided electricity distribution services is an imbalance in the existing incentives for the fulfillment of obligations in the wholesale and retail electricity markets. The risk of losing the Wholesale Electricity (Capacity) Market entity status due to failure to comply with extremely tight payment schedules motivates customers (mainly, suppliers of last resort) to give priority to the obligations to pay for electricity purchased in the Wholesale Electricity (Capacity) Market while paying for electricity distribution services on a secondary basis.

With the aim of minimizing the risk of nonpayments, the Company implements the Program for Improving the Efficiency of Measures to Reduce Receivables for Electricity Distribution Services.

Since the Company does not perform any direct operating activities and its core business is corporate management of SDCs, there are no risks associated with possible changes in any prices of raw materials and services used by the Company or associated with possible changes in any prices of the Company’s products and/or services, which risks may affect the Company’s activities and the performance of its securities-related obligations.

Country and Regional Risks

Since PJSC ROSSETI does not perform any operating activities and is only in charge of corporate management, country and regional risks are primarily incurred by the Company's SDCs.

Risks associated with the political and economic situation in the country and regions.

Country and regional risks incurred by the Company and SDCs are determined primarily by macroeconomic factors existing globally, nationwide, and at regional level. These factors may cause the risks that will eventually lead to a reduction in the Company's and SDCs’ revenues and affect their shareholder value.

31

The volatile external conditions, international sanctions, lower credit ratings, higher inflationary pressures contribute to the ROSSETI Group's economic decline in the regions and an increase in borrowing costs and lead to the risk of a potential growth in SDCs' receivables.

With the aim of mitigating the macroeconomic risk, the Company and SDCs take comprehensive measures to optimize the share of borrowings in their total capital, take out fixed interest rate loans, and enhance the efficiency of operating and investment expenses.

The impact of macroeconomic risks on the volume of electricity distribution services provided by the Company's SDCs and measures to minimize the consequences of materialized risks are described in more detail in Section 2.4.1 "Industry-Specific Risks."

Risks associated with possible military conflicts and their implications, imposition of the state of emergency, and strikes in the regions.

A significant contributor to the uninterrupted operation of the Russian electric grid sector will be efforts to ensure the safety and security of its facilities. Damage to SDCs' activities can be caused by illegal interference in SDCs' operations, including acts of terrorism, as well as international terrorism, and by nationalists from certain countries. These acts, along with potential governmental counterterrorism measures and the imposition of the state of emergency in certain regions where the Company's SDCs operate, can have an adverse effect not only on fulfilling SDCs' functions specified in the Strategy for Development of the Electric Grid Sector of the Russian Federation in general but also on the amount of investment and on the value of the Company’s securities. However, the Company estimates that these risks are unlikely to occur.

Risks associated with the geographical characteristics of the country(ies) and regions, including the potential effects of natural disasters, interruptions to transportation due to remoteness and/or inaccessibility, etc.

The Company's SDCs operate in a considerable area of Russia with diverse climatic, natural, and temperature conditions. Therefore, there are risks associated with natural and climatic emergencies (hurricanes, heavy rains, high water and floods, snow drifts, icing, power outages due to fires, domestic gas explosions, etc.). This can result in interruptions to the region's electricity supply and transportation.

Risks associated with high likelihood of natural disasters and with possible interruptions to transportation due to remoteness and/or inaccessibility are assessed by the Company as negligible.

Financial Risks

Risks associated with exchange rate changes

Currently, all revenues and an overwhelming majority of operating and investing expenses of the Company and its SDCs are denominated in rubles. PJSC ROSSETI and its SDCs do not have any foreign currency-denominated loan debts or any investments in foreign companies whose value is exposed to risks associated with exchange rate changes.

Exchange rate changes have a certain adverse impact on the Company’s financial and economic performance. Information about the impact of currency fluctuations on the implementation of capital investment programs is contained below.

Risks associated with interest rate changes

The Company and SDCs borrow to refinance debts and finance SDCs’ capital investment programs. The loan portfolio of the Company and SDCs consists mostly of fixed interest rate instruments. To reduce the risk of higher interest costs, the Company and SDCs take measures to minimize the loan portfolio, including by means of optimizing their operating expenses and capital investment programs and by means of using their own funds to partially repay debts.

Risks associated with the effects of inflation

Changes in the consumer price index have certain effects on SDCs’ interest costs, profitability, and, consequently, the financial condition of the Company and SDCs and their ability to perform obligations. The

32

government’s monetary policy and the electric grid sector’s tariff regulation policy give consideration to the consumer price level, changes in the actual purchasing power of the ruble, and the situation in the electricity markets, which impacts companies’ profitability.

Risks associated with possible failure to receive money from bank accounts

The Company and its SDCs are provided with payment and cash services by Russian major banks, which minimizes the risk that they may fail to receive money from bank accounts. The risk associated with the possible nonrepayment of fixed-term deposits is minimized by setting ceiling limits on deposits with counterparty banks (as a percentage of banks’ asset value as of the latest balance sheet date) and monitoring compliance with such limits.

Risks associated with impaired financial stability and financial solvency

These risks are determined by the simultaneous and unidirectional effects of several factors, and it is reasonable to single out the following factors:

■ set tariffs;

■ lower financial solvency of electricity consumers;

■ lower volume of electricity distribution services provided;

■ inflation factors (higher loan interest rates, inflation, changes in US dollar and euro exchange rates, etc.);

■ volatility in the financial markets;

■ increased number of network connection requests.

The Company and SDCs manage the risk of impaired financial stability and financial solvency by optimizing their capital structure, monitoring compliance with debt limits under the Regulations for Credit Policy approved by the Boards of Directors of the Company and SDCs, pursuing a policy on receivables and payables management, and implementing other measures that help minimize the potential adverse impact of this risk on the Company and SDCs.

Legal Risks

The Company builds its activities on compliance with the applicable legal regulations of the Russian Federation, including currency, tax, and customs laws, and monitors amendments thereto on an ongoing basis.

The Company does not expect any short-term major risk in its financial and economic activities associated with radical changes in tax law and currency control or changes in the rules of customs control and duties.

In general, to minimize various legal risks the Company, on a mandatory basis, conducts preliminary legal review of planned corporate procedures, conducted transactions and other aspects of financial and economic activities provided for by the applicable laws and/or Articles of Association of the Company. Additionally, the Company updates local regulatory documents with respect to claim-related work.

Reputational Risk

Activities of the Company and SDCs are aimed at fulfilling all of their obligations to customers and counterparties. The Company and SDCs are constantly working to secure a reliable and uninterrupted power supply, improve the quality of their services, and increase their customer focus, i.e. achieve the goals defined by the Strategy for Development of the Electric Grid Sector of the Russian Federation. The successful accomplishment of these goals and objectives determines the Company's reputation to a great extent.

In order to mitigate this risk, the Company and SDCs pursue the uniform Policy on Society, Customer, and Government Relations and interact on a constant basis with all stakeholders via several communication channels, including the Internet.

33

Since SDCs of PJSC ROSSETI are natural monopolies, it is unlikely that they will be affected by a considerable outflow of customers and suppliers or by a decrease in the volume of services due to the possible impact of adverse reputational factors.

Strategic Risk

The long-term development areas of the entire electric power industry as a key industry and the Company and SDCs are determined by the government. Ordinance of the Government of the Russian Federation No. 511-r of April 3, 2013, approved the Strategy for Development of the Electric Grid Sector of the Russian Federation.

The Company's Long-Term Development Program approved by the Board of Directors of PJSC ROSSETI is intended to ensure the achievement of the targets set by the Strategy with due consideration to PJSC ROSSETI's authority and the current economic situation.

The Company's Long-Term Development Program is an internal policy document covering the period from 2015 to 2019 and containing the lists of mechanisms and measures to ensure the achievement of PJSC ROSSETI's strategic goals.

In order to minimize possible risks associated with the achievement of the Company's strategic goals and objectives due to potential changes in the internal and external environments of the Company's and SDCs' operations, the Company organizes the periodic monitoring of how the Long-Term Development Program is carried out and regular external audits of its implementation.

Risks Associated with the Issuer’s Activities

Risks associated with pending legal proceedings in which the issuer participates.

In the reporting period, legal proceedings were initiated by IDGC of Centre, PJSC’s minority shareholders against the Company. PJSC ROSSETI acts as the respondent in the legal proceedings. The risks related to the consideration of this dispute are mainly reputational.

Risks associated with the impossibility of extending the issuer’s license to perform a certain type of activity or use constrained assets (including natural resources).

The above-mentioned risks do not exist, since the Company neither performs nor plans to perform any licensable activities specified in the laws of the Russian Federation or use constrained assets (including natural resources).

Risks associated with the possible liability of the issuer for third-party debts, including the issuer’s subsidiaries.

Currently, the Company is not liable for any third-party debts since the Company did not collateralize such obligations. However, the Company provided suretyship to secure the performance by PJSC ROSSETI’s

subsidiaries of their obligations as part of the implementation of the Smart Grid Construction Investment Project pursuant to Ordinance of the Government of the Russian Federation No. 1059-r of June 16, 2014.

Risks associated with the possible liability of the issuer for third-party debts and obligations are assessed by the Company as negligible.

The Company can assume liability for the debts owed by its SDCs if the Company’s instructions binding upon SDCs cause losses or bankruptcy to such SDCs. However, the Company uses its best efforts to prevent such situation and maintain SDCs’ financial stability. The above-mentioned risks are unlikely to occur.

Risks associated with the possible loss of customers accounting for at least 10 percent of total revenue from the sale of the Company’s products (work, services).

Since the Company’s core business is the corporate management of SDCs, the Company does not incur the risk of customer loss.

34

The Company does not conduct direct operating activities, and its core business is the corporate management of SDCs. The principal risks associated with SDCs’ activities are as follows:

■ operational and technological risk;

■ investment (project) risk.

Operational and technological risk.

One of the main type of operating activities conducted by the Company’s SDCs is to provide electricity transmission and distribution services. Operational and technological risks affecting this activity type include the risk of impaired electricity supply reliability.

The following factors contribute to operational and technological risks:

■ natural and anthropogenic emergencies impairing the operating capability of electric grid equipment;

■ a high proportion of equipment with an expired standard operating life, delays in deciding on measures in relation to equipment;

■ nonfulfillment of regulatory and technical requirements as related to failure to conform to the permissible values of the process parameters of electric grid equipment’s operation; mistakes made by operating personnel and resulting in emergency situations.

If these risks materialize, this may have a material economic and reputational effect on the Company.

In order to minimize the impact of the above-mentioned factors, the Company and SDCs take the following organizational and technical measures:

1. Raise the level of traceability and manageability in the electric grid sector and reduce the time of remedying emergency situations:

■ optimizing operational process and situation control systems;

■ developing and improving automated operational process and situation control systems;

■ improving systems for analyzing process failures and forecasting their consequences;

■ expanding the stock of reserve power supply equipment and the stock of vehicles and special equipment for accident recovery work;

■ improving the emergency reserve management system;

■ enhancing the performance of mobile accident recovery crews and improving the quality of their personnel;

■ cooperating with electricity industry entities, the Ministry of Energy of the Russian Federation, the Ministry of Civil Defense, Emergencies and Disaster Relief of the Russian Federation, the Hydrometeorological Centre of the Russian Federation (including in such areas as wildfire suppression, control of critical changes in water body levels, glaze ice control, control of excess wind loads, and control of abnormal weather conditions), executive authorities of constituent entities of the Russian Federation, and Electricity Distribution Security Headquarters.

PJSC ROSSETI created a common database relating to the available resources of PJSC ROSSETI’s

SDCs and preparedness for remedying emergency situations in the electric grid sector: the availability of the emergency reserve, backup power sources, mobile accident recovery crews, and mobile substations and factory assembled modular switchgear units; agreements with the Ministry of Civil Defense, Emergencies and Disaster

Relief of the Russian Federation, the Federal Service for Hydrometeorology and Environmental Monitoring of the Russian Federation, contractors, PJSC ROSSETI’s SDCs and their branches, and territorial grid organizations; participation in the federal commissions (headquarters) ensuring power supply security for constituent entities of the Russian Federation; information on significant accidents, remedied large-scale power outages, joint exercises, members of the Headquarters, and contact persons; schematic maps of

35

operated electric grid facilities, emergency preparedness certificates; interaction workflows for organizing accident recovery work at substations (overhead lines).

2. Reduce the proportion of equipment with an expired standard operating life and switch over to repairs “as necessary”:

■ implementing and developing the production asset administration system;

■ rehabilitating and modernizing electric grid facilities;

■ putting newly built facilities into operation;

■ carrying out the target-oriented programs to replace equipment;

■ implementing the energy conservation and energy efficiency enhancement program.

3. Provide training and advanced training for production personnel and control their activities. Develop the technical diagnostics system for electrical equipment.

Investment (project) risk.

Since PJSC ROSSETI does not perform any operating activities and is only in charge of corporate management, the investment (project) risk is incurred by the Company’s SDCs.

The implementation of SDCs’ capital investment programs makes it necessary to mobilize both internal and borrowed considerable financial resources conforming to the regulation parameters.

In this connection, one of the investment risks is the risk of decreased financing sources for the capital investment programs of PJSC ROSSETI’s SDCs if the Company’s financial and economic condition becomes worse.

As part of efforts to mitigate the investment risk, the capital investment programs of PJSC ROSSETI’s

SDCs take account of the following key efficiency criteria:

■ raising the reliability and affordability of the grid infrastructure;

■ reducing the physical deterioration of electric grid facilities and modernizing them;

■ achieving a high utilization rate of commissioned facilities;

■ optimizing technical solutions based on the necessity of excluding the use of imported equipment and materials whose value is highly dependent on foreign exchange rates.

The Company conducts the annual monitoring of unit construction costs of investment projects as part of the benchmarking and comparative analysis of unit construction cost indicators of subsidiaries and dependent companies of subsidiaries/subsidiary subsidiaries and dependent companies of PJSC ROSSETI and their branches.

The inadequate financing of capital investment programs and the need to optimize such programs involves the risk that tariff revenues may go down in the event of failure to carry them out. There are also risks of the delayed commissioning of facilities covered by SDCs’ investment programs, possibly due to the nonperformance or delayed performance by contractors and suppliers of their obligations. With a view to mitigating such risks and improving the quality of investment project implementation, the Company fulfills the requirements of methodological and administrative documents and uses independent construction inspections at facilities of PJSC ROSSETI’s SDCs.

36

8. ROSSETI Group Structure

Subsidiaries and dependent companies as of December 31, 2016

Name Location

TRANSMISSION GRID COMPANIES

FGC UES, PJSC Moscow

INTERREGIONAL GRID COMPANIES

JSC Tyumenenergo Surgut

IDGC of Volga, PJSC Saratov

IDGC of Northern Caucasus, PJSC Pyatigorsk

IDGC of North-West, PJSC Saint Petersburg

PJSC IDGC of Siberia Krasnoyarsk

IDGC of South, JSC Rostov-on-Don

IDGC of Urals, JSC Yekaterinburg

PJSC MOESK Moscow

IDGC of Center and Volga Region, PJSC Nizhni Novgorod

PJSC LENENERGO Saint Petersburg

IDGC of Centre, PJSC Moscow

DISTRIBUTION GRID COMPANIES

JSC Yantarenergo Kaliningrad

PSC TDC Tomsk

Chechenenergo, JSC Grozny

Kubanenergo Krasnodar

REGIONAL RETAIL COMPANIES

JSC Karachaevo-Cherkesskenergo Cherkessk

37

AO Kalmenergosbyt Elista

AO Tyvaenergosbyt Kyzyl

Kabbalkenergo, JSC Nalchik

Dagestan Energy Supply Company, PJSC Makhachkala

Sevkavkazenergo, PJSC Vladikavkaz

Ingushenergo, PJSC Nazran

NURENERGO, JSC Grozny

R&D COMPANIES

JSC REC IDGC Moscow

JSC VNIPIENERGOPROM Moscow

OAO SKB VTI Moscow

JSC ENIN Moscow

Urals Power Engineering Company Yekaterinburg

OAO SevZap NTC Saint Petersburg

JSC VPEC Samara

CONSTRUCTION, PROCUREMENT, AND SERVICE ORGANIZATIONS

JSC Power Grid Optical Networks Engineering Moscow

AO Engineering Center UES Real Estate Moscow

JSC NWEMC Saint Petersburg

AO Grozenergo Grozny

OOO IT Energy Service Moscow

AO ZES Moscow

38

9. Responsibility Statement

The Management Board confirms that to the best of their knowledge:

1. The financial statements, prepared in accordance with International Financial Reporting Standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and the undertakings included in the consolidation taken as a whole; and

2. The management report includes a fair review of the development and performance of the business and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that it faces.

By order of the Board of Directors,

D. V. Nagovitsyn

Chief Accountant

39

10. Glossary

JSC «ROSSETI» (ROSSETI) Joint Stock Company «ROSSETI»

AC Authorized Capital

GVA Gigawatt-ampere

GW Gigawatt

FES Fuel and energy sector

FGC Federal Grid Company of Unified Energy system, Joint Stock Company

FTS Federal Tariff Service of Russia

IDGC Interregional Distribution Grid Companies

IFRS International Financial Reporting Standards

KPI Key performance indicators

kVA Kilovolt

MICEX Power Index

MICEX Power Index. The Sector Indices are market capitalization weighted indices calculated based on prices of the most liquid shares of Russian issuers operating in the relevant economic sectors, admitted to trading on MICEX Stock Exchange, and included in the Broad Market Index calculation base.

MSCI Russia A Russian stock market index included in the MSCI Emerging Markets Index

MVA Megavolt-ampere

MW Megawatt

NC Network connection

OL Overhead line

RAB Regulatory Asset Base, a system of long-term tariff regulation aiming to encourage investment in the construction and modernization of grid infrastructure and stimulate grid organizations to implement cost efficiency measures

RGC Regional Grid Companies

SDCs Subsidiaries and dependent companies

TGC Territorial Grid Companies

TL Transmission/Distribution line

UNEG UNEG Unified National Electric Grid

UPS UPS United Power System of Russia

40

11. Contacts

Registered address: 4, Belovezhskaya st., Moscow, 121353, Russian Federation

Correspondence address: 4, Belovezhskaya st., Moscow, 121353, Russian Federation

Location: 4, Belovezhskaya st., Moscow, 121353, Russian Federation

Phone: +7 495 995-5333 (from 09.00 till 18.00 Moscow time)

Phone/Fax: +7 495 664-8133

E-mail: [email protected]

41

12. Application