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Rating Action:

Moody's Assigns Ba2 Rating to MOESK, Positive Outlook

26 Oct 2007
Moody's Assigns Ba2 Rating to MOESK, Positive Outlook

Moscow, October 26, 2007 -- Moody's Investors Service has today assigned a Ba2 corporate family rating with a positive outlook to OJSC MOESK ("MOESK", or "the company"), the largest regional electricity distribution grid company in Russia with a focus on the Moscow region. At the same time, Moody's Interfax Rating Agency, which is majority owned by Moody's, assigned a Aa2.ru national scale rating ("NSR") to the company.

According to Moody's and Moody's Interfax ("Moody's"), the Ba2 global scale rating reflects the company's global default and loss expectation, while the Aa2.ru NSR reflects the standing of the company's credit quality relative to its domestic peers.

RATING RATIONALE

MOESK's ratings reflect: (i) the company's position as the monopoly distribution grid business in the Moscow region that will be further reinforced in the short-term by MOESK consolidating the Moscow city distribution grid company (MGESK) as well as the Municipal power grid company; (ii) MOESK's strategic and social importance for the highly populated and rapidly growing capital region combined with the plans for significant upgrade investments into its asset base, which should ensure some degree of the Moscow city government's or federal government's support at least for the foreseeable future; (iii) a supportive tariff regulation that recognizes the importance of MOESK's business, with the potential medium-term introduction of a Regulated-Asset-Base ("RAB")-centred regulation to support the company's ability to invest and fund its investments into its asset base; (iv) a good cushion in financial metrics allowing for a meaningful debt increase, providing the company with some initial flexibility as to the timing and choice of funding sources; (v) opportunities to substantially increase revenues provided by the fast growing economy of the Moscow region, with connection charges to become an important source of revenues and hence an ability to finance investments independently of the success of the regulatory reforms.

At the same time, MOESK's ratings are constrained i) uncertainties associated with the restructuring process of the Russian power sector, while the company's leading role in the consolidation of the distribution grid business in the Moscow region will also contain some risks until this consolidation has been successfully executed and implemented; (ii) MOESK's exposure to a developing regulatory environment in the sector, with a RAB-based regulatory regime to come into force and prove itself as clear, transparent and independent; (iii) a large investment programme that is driven by the company's outdated and insufficient distribution assets and which may further increase due to potential increases in costs of new construction and asset renovation in the Moscow region; while the sheer magnitude of this programme itself may challenge the company, we also believe that due to the similar investment plans of many other Russian power utilities MOESK could face bottlenecks in both skills and resources required to undertake the investment programme; such a significant investment programme therefore contains a significant execution risk; (iv) risk of a rapid deterioration in MOESK's credit metrics as the investment programme is expected to be largely debt-funded; (v) potential pressure on liquidity, given the company's limited flexibility in implementing overdue and necessary investments; (vi) lack of a track record as a standalone entity following the break-up of Mosenergo in 2005; (vii) and lastly, the ratings are also constrained by additional risks related to Russia's general operating environment, from a political, economic, judicial perspective, as well as due to the yet developing corporate governance standards.

MOESK has been chosen as the consolidation center of the Moscow region's distribution grid assets to become one of 11 inter-regional distribution grid companies (the Far East grid business not counted) as part of the target configuration of Russia's post-restructuring power sector. MOESK operates in Russia's most wealthy Moscow region. Its position as a regulated monopoly in this market that is facing a shortage of electricity supply allows MOESK to benefit in the long-term from the initiated additions to the generation and transmission capacities. In the short- and medium-term MOESK should also benefit from gradually increasing transmission volumes and grid connection requests.

The consolidation of the region's grid distribution assets under the helm of the company is at its initial stage, and its largest shareholders have agreed that the company should start corporate procedures, in particular increasing its share capital in order to consolidate MGESK, the Moscow city grid distribution company. After the latter is consolidated during 2008, MOESK is expected to further consolidate other distribution grid assets from the Moscow city and Moscow regional governments. The objective of the consolidation process is to ensure well managed and reasonably invested electricity distribution grid operations to support the Russian capital's day-to-day activities, taking into account lessons learned from the May 2005 blackout in Moscow which has revealed risks of an outdated and underinvested grid, both from social and political points of view.

The central scenario is that the company will remain under control of the state and/or state-controlled entities, with the Moscow government's stake in the enlarged MOESK to increase during 2008, while a meaningful shareholding and impact by federal government controlled entities is expected to remain at least in the medium term. The state's support at both local and federal levels should at least partially mitigate risks associated with the company's large investment programme of Rbl242 billion planned for 2007 to 2010, including MGESK's programme. With MOESK's strategic importance recognized, the regulatory authorities both at local and federal levels are expected to be supportive to the company's investment needs, in particular in the upcoming period of transition towards a RAB-based regulation.

The investment programme is the key challenge faced by the company. Despite a generally supportive regulation, decisions on future tariff growth will be politically biased. Thus, transmission revenues, even with increasing revenues from connection charges added, will be insufficient for the company to finance its investments without raising external debt. Additionally, MOESK has yet to confirm its ability to generate sustainable high revenues from recently introduced regulated connection charges as this is targeted to be an important source of its cash flow generation capacity.

Given the size and scale of MOESK's investment programme and the company's limited flexibility in changing the implementation timetable due to the political significance and the government's close involvement, MOESK's current cushion in credit metrics is expected to largely decrease in the upcoming years. MOESK should remain free cash flow negative in the mid term and could face liquidity issues should it fail to maintain a debt profile dominated by long-term maturities. That said, Moody's draws some comfort from the likelihood of support from the state in different forms, first of all from the Moscow government.

Moody's notes that the company successfully issued a 5-year Rbl 6 billion bond in the Russian bond market in 2006. Up to the end of 2007, MOESK plans to issue a Rbl 10 billion eurobond to refinance attracted bridge facilities. Under the circumstances, Moody's points out to the lack of unused committed credit facilities in addition to a Rbl 1 billion bank facility available until the end of 2007. However, Moody's understands that the company has good access to Russian large state-owned banks due to the support from the Moscow city government and large federal-government controlled shareholders.

The rating outlook is positive, incorporating the likely strengthening of the Moscow government's shareholding in MOESK during 2008, which also increases the likelihood of support.

Successful consolidation of MGESK, coupled with MOESK's operating performance being strong and in line with projections, as well as the Moscow city government's stake increasing to 25% could have a positive impact on the ratings. Better clarity with principals and timing of potential introduction of a RAB-based regulation, could have the same impact. The company's ability to increase operating profit margins and cash flow generation ahead of projections may also positively influence the rating.

A negative shift in the regulatory regime affecting the company's credit metrics may negatively affect the rating. A negative pressure may result from the leverage exceeding the maximum of total debt to EBITDA ratio of 3x and RCF to total debt coverage falling down below 20-25%.

COMPANY SUMMARY

Headquartered in the city of Moscow, OJSC MOESK is Russia's largest regional power distribution grid company servicing the Moscow region and the city of Moscow, with total number of consumers of circa 1.4 million. MOESK is a regulated monopoly, whose electricity transmission revenues accounted for about 90% of its 2006 total revenues of Rbl 25.5 billion. The largest shareholders of MOESK are RAO UES holding a 50.9% stake in the company, Gazprom (28.2%) and the Moscow government (7.6%).

NATIONAL SCALE RATINGS

Moody's Interfax Rating Agency's National Scale Ratings (NSRs) are intended as relative measures of creditworthiness among debt issues and issuers within a country, enabling market participants to better differentiate relative risks. NSRs in Russia are designated by the ".ru" suffix. NSRs differ from global scale ratings, as assigned by Moody's Investors Service, in that they are not globally comparable to the full universe of Moody's rated entities, but only with other rated entities within the same country.

ABOUT MOODY'S AND MOODY'S INTERFAX

Moody's Interfax Rating Agency specialises in credit risk analysis in Russia and is 51% owned and controlled by Moody's Investors Service, a leading provider of credit ratings, research and analysis covering debt instruments and securities in the global capital markets. Moody's Investors Service is a subsidiary of Moody's Corporation (NYSE: MCO). Further information is available at www.moodys.com.

Frankfurt
Johannes Wassenberg
Managing Director
Corporate Finance Group
Moody's Deutschland GmbH
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SUBSCRIBERS: 44 20 7772 5454

Moscow
Ekaterina Botvinova
Vice President - Senior Analyst
Corporate Finance Group
Moody's Eastern Europe
Telephone: +7 495 641-1881
Facsimile: +7 495 641-1897

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