Fundamental Reform of the Energy Sector is Necessary
Proposals for Ukraine: 2010 - Time for Reforms
Reform the Energy Sector, Chapter 5
Independent International Experts Commission
Kyiv, Ukraine, Feb 2010, p 45 - 51
The paramount tasks in energy policy are to ensure stable energy supply, develop Ukraine’s energy production, raise the country’s energy efficiency, and enhance energy security. Accomplishment of these tasks demands a market economic environment in the energy sector, with the transformation of pricing policy, enterprise restructuring, improved governance, and introduction of a competitive market.

The Ukrainian energy sector is riddled with such serious problems that it receives its own chapter in this action program report.

[1] First, the Ukrainian economy is one of the most energy intensive in the world because of the very low prices offer no incentives to invest in energy saving. In the next five years, Ukraine should be able to cut its energy consumption by half relative to GDP, as Poland and Slovakia have done. Then, Ukraine would not need to import any natural gas.

[2] Second, current energy pricing subsidizes imports and penalizes domestic production, which boosts imports at the expense of domestic energy production.

[3] Third, the energy sector has probably been the main source of corrupt incomes in Ukraine.

[4] Fourth, because of the poor management of the energy sector, energy supplies are not sufficiently secure.

[5] Fifth, Ukraine has been losing transit business because of its poor reputation as a reliable transit country. The worst problems pertain to the gas sector, and the electricity sector is highly dependent on gas supply. The coal sector has its own problems. Oil trade is reasonably free, though oil pipeline transportation, ports, railways and terminals suffer from similar problems as gas pipelines. The energy sector is probably the biggest source of waste and corruption in the Ukrainian economy.

To resolve these problems, a fundamental reform of the energy sector is necessary. The key object of reform must be Naftogaz Ukrainy. Several reforms should be pursued in parallel. Naftogaz Ukrainy should be divided into several separate companies. Production should be separated from transportation.

Non-core activities should be sold off. The remaining state companies should be given proper governance with professional, competent supervisory boards, including independent directors, and international auditing of annual reports should be made public.

All energy prices should be raised to a level that will cover the costs of production plus a competitive profit margin. All price subsidies and cross-subsidization should cease, while social compensation should be provided for truly needy groups.

The pipeline system should offer equal access to all at market-related prices. Over time, producing companies should be sold off. Private investment and competition in the oil and gas sector in Ukraine should be given legal protection.

However, all these reforms have to be undertaken gradually and coordinated, as has been proposed by the European Union (EU) because presently, Naftogaz has such large debts and liabilities that it would go bankrupt if it lost its profitmaking parts.

Its creditors need to be consulted during its restructuring. Gas reform can deal a major blow to corruption; reduce Ukraine’s need for gas imports, turning its current account into surplus; improve state finances; and guarantee Ukraine’s energy security.

The energy sector harbors large commercial and bureaucratic interests, and any reform will hurt some of these interests. Therefore, a newly elected president needs to act fast and hard to accomplish energy reform, and Ukraine needs international support to carry out these complex reforms. The EU has engaged very constructively through its agreement with Ukraine on reform and investment in the Ukrainian Gas Transit System.

Gas reform should be carried out on the basis of this agreement, which is also supported by all the international financial institutions and the United States. Gas reform should include investment to modernize the Gas Transit System and generate energy savings.

One important purpose of gas transit reform is to make Ukraine attractive as a reliable transit country. Ukraine is making large revenues each year on gas and oil transit, which gives the country a large surplus in its service balance of payments.

At present, many pipeline projects are threatening to bypass Ukraine and reduce its market share: Blue Stream-2, Nord Stream, South Stream, and Nabucco for gas and the Baltic Pipeline System for oil. Ukraine has a vital interest in protecting and increasing its transit volumes and therefore income, and it must first prove itself as a reliable transit country.

A patent threat to Ukraine’s position as a seller of transit services has been its poor relations with Russian Gazprom. The Ukrainian-Russian ten-year agreement of January 19, 2009, on supply and transit of gas made great advances toward transparency, elimination of a middleman, and market-oriented pricing and thus toward more stable gas relations with Russia.

However, the volumes assigned in the agreement were far too large. They have been renegotiated for the first two years of the agreement, but it would be desirable to reach a more stable and flexible solution.
Recommendations for the Entire Energy Sector
       1.  The government should develop a realistic energy pricing policy. The Ukrainian government has agreed with the International Monetary Fund (IMF) that gas prices for all categories of privileged consumers of natural gas, electricity, and coal should be increased by 20 percent a quarter until they reach a cost recovery level. The abolition of all these price wedges will eliminate a major source of corruption, thus laying the foundation for energy efficiency. All energy prices should be brought to the level of full cost recovery plus a profit margin for operators as soon as possible.
       2.  The Cabinet of Ministers should draft and the parliament adopt the Law on the National Energy Regulatory Commission of Ukraine to reinforce and unify the regulation of all natural monopolies in one strong and competent independent regulator. It should control pricing of services provided by all natural monopolies, ensuring a balance of interests between producers, consumers, and state. It should guarantee reliable supply of high-quality services to consumers at fair prices, while making sure that the natural monopolies can make sufficient profits to be able to develop.
       3.  At the same time as the price hikes, the Cabinet of Ministers should introduce a new system of targeted social assistance for the least protected groups of consumers who suffer because of high gas, electricity, and coal prices.
       4.  Energy saving. Ukraine needs to elaborate, adopt, and implement a program for energy saving. The country should continue to engage in the sale of carbon emissions rights under the Kyoto Protocol and encourage investment in energy-saving technologies.
       5.  Investment opportunities in the oil and gas sector in Ukraine must improve for both domestic and foreign investors. At present, only a few, mainly small, private energy companies are producing oil and gas in Ukraine, besides subsidiaries of the state conglomerate Naftogaz Ukrainy. Although Ukraine has substantial oil and gas assets, its oil and gas production has been stagnating for many years.

            Moreover, vast gas assets are known to exist on the Ukrainian part of the Black Sea and Azov Sea shelves. Ukraine should set the target of doubling its production of oil and gas within a decade and become self-sufficient in energy. Investors and producers must be provided with secure property rights, free market prices, and stable and reasonable rules of taxation.
       6.  Open up state oil auctions. Throughout 2008, the prices at auctions for oil and gas condensate were much lower than market prices because the management of Ukrnafta kept down their prices in the interest of related businessmen, even though the state owns a majority of the shares in Ukrnafta.
            The Cabinet of Ministers has repeatedly tried to open up these “auctions,” most recently with a decree On Amendments to the Regulation on Organization and Implementation of Auctions for Sale of Oil, Gas Condensate, Natural and Liquefied Gas, and Coal, adopted on December 23, 2009. It prohibits related buyers from participating in auctions and sets a minimum price as per world prices. Yet, so far the Cabinet of Ministers has not carried sufficient weight to resolve this problem.
Gas Sector Reform: Crucial for Success
Gas reform is probably the most important reform in the Ukrainian economy. Ukraine’s gas sector is the most unreformed, highly monopolized, and non-transparent part of the economy, and it is characterized by extensive corruption. Most prices are far below the market level, as pricing is susceptible to political leverage.

In addition, restrictive regulation, poor property rights, and high taxes deprive producers of any economic incentive to increase production of natural gas, invest, or serve their consumers appropriately. Naftogaz Ukrainy, which was formed as late as in 1998 for political reasons, has never functioned acceptably and needs to be broken up.

Gas reform is necessary to ensure stable gas delivery to Ukrainian consumers and enhance the transit of gas through Ukraine to European consumers, increase the sector’s efficiency, attract investment for the reconstruction and modernization of the gas transit system, and fulfill its international obligations.

The key elements of reform are the creation of a competitive market for natural gas, economically sound gas price policy, and transparency.

Absence of a competitive gas market. The fundamental problem with the Ukrainian gas sector is the nonexistence of a market because of complete monopolization.

Economically unsound control of gas prices. The long-standing political practice of setting natural gas prices for the population, state-funded organizations, and municipal heating enterprises lower than what Naftogaz Ukrainy pays to Gazprom has made Naftogaz incur chronic losses to the tune of $2billion to $3 billion a year. The government has to scramble and exploit every opportunity to find funding for these payments to Gazprom.

It has used loans from state-owned banks, IMF funding, international reserves of the National Bank of Ukraine, and advance payments by Gazprom for gas transit to Europe. Naftogaz Ukrainy is heavily indebted and effectively bankrupt if it does not receive large annual allocations from the state budget.

Low tariffs on transportation, distribution, and delivery of natural gas. These low tariffs make it impossible for the operators to maintain or modernize underground storage facilities and gas pipelines. As a consequence, the whole infrastructure is neglected.

Poor payment discipline. During the first eleven months of 2009, Naftogaz Ukrainy was paid for only 87 percent of the natural gas it delivered to its consumers, and its indebtedness rose accordingly.

Non-transparency in the gas sector. Incredibly, although Naftogaz Ukrainy is a state-owned corporation, it publishes no annual report for itself or its many daughter companies. Natural corollaries are non-competitive and expensive procurement and high costs of borrowing.

Significant gaps in legislation. Legislation for the gas sector consists mainly of decrees and regulatory acts and not of laws, which makes enforcing rules impossible.

Poor compliance with international obligations. Ukraine has undertaken extensive international commitments in the gas sector:

        [a] the Joint EU-Ukraine Declaration, which was adopted at the International Investment Conference on the Modernization of the Ukrainian Gas Transit System on March 23, 2009 (the so-called Brussels Declaration);
        [b] the Memorandum of Economic and Financial Policies between the Cabinet of Ministers of Ukraine and the International Monetary Fund of October 26, 2009;
        [c]  accession of Ukraine to the Energy Community (on December 18, 2009); and 
        [d]  commitments to take measures to gradually bring national legislation into compliance with EU legislation in certain areas, including the energy sector, according to Article 51 of the Partnership and Cooperation Agreement between Ukraine and the EU and also its member states as of June 16, 1994.

Ukraine’s international commitments in the gas sector consist of specific tasks: harmonizing national legislation with EU legislation; reforming the pricing system; introducing market principles; developing and implementing gas sector reforms, including reforming Naftogaz Ukrainy; improving the independence of the regulatory authority; and preparing an action plan on the renovation and modernization of Ukraine’s gas transportation system.

The prerequisite for membership of the Energy Community and candidate status for accession to the EU is implementation of the energy chapter of the aquis communautaire in full. This obliges Ukraine to implement the provisions of the EU “third energy package.” Three important legislative acts concern an Agency for the Cooperation of Energy Regulators, conditions for access to natural gas pipelines, and common rules for the internal natural gas market.

Ukraine’s failure to fulfill its obligations to the European Commission, the IMF, and the Energy Community could prevent it from receiving further IMF funding as well as international credits for the reconstruction and modernization of the gas transit system, which would damage Ukraine’s international image. But the main thing is that Ukraine would suffer from the absence of real gas reform.

This is also the view of Ukraine’s international partners, notably the EU, the IMF the World Bank, and the United States. They all see gas reform as the key condition for Ukraine’s economic success. Therefore, they have concluded the three aforementioned agreements with Ukraine on gas reform.

Various Ukrainian bodies have drafted many bills on energy reform, which have tended to stay as drafts and rarely correspond to Ukraine’s international commitments. Recently the draft Law on the Principles of Functioning of the Natural Gas Market Functioning of October 22, 2009 was submitted to the Verkhovna Rada. It prescribes eliminating the natural gas monopoly, introducing competition in the domestic natural gas market, economically sound pricing, and energy-saving technologies,

Yet there is no need to reinvent the wheel. Ukraine has committed itself to quite specific reforms in its international agreements, which should guide Ukraine’s reforms. A key EU directive vital for Ukraine is to separate transportation of natural gas from production as well as distribution. Specifically, the Gas Transit System, that is, the company Ukrtransgaz, should be legally separated into an independent company.

The same is true for Ukrtransnafta, the trunk pipeline company. Similarly, the various functions of the company ChornomorNaftogaz should be divided into separate companies—production of oil and gas offshore on the Black Sea and Azov Sea shelves, gas transportation, and storage of gas in Crimea.

The recent EU laws and regulations in the “third energy package” adopted in July 2009 have not been addressed in the draft law. The key issue is This is an action program for the first year of a new presidency unbundling of natural gas transportation and distribution functions, and the new EU legislation has expanded the legal demands for market creation.

The EU member states can choose one of the three options to operate vertically integrated companies.

[1] The first option envisages compulsory separation of their property by selling pipelines to an independent operator without right to a controlling interest.

[2] The second option allows vertically integrated companies to remain the owner of their pipelines provided they are managed by an independent operator appointed by the national government upon prior approval of the European Commission.

[3] The third option foresees the retention of vertically integrated companies, monitored by a special supervisory authority, with an independent subsidiary in charge of daily operation of the pipelines. The vertically integrated company would keep the pipelines as financial assets on its balance sheet.
The current Ukrainian draft law is designed for the second and third options. The Ukrainian parliament has prohibited the privatization of the gas transit system and the gas reservoirs for fear of threats to the country’s national security. However, rules ensuring independence of a gas pipeline operator need to be reinforced. The powers and obligations of independent operators of gas pipelines and gas distribution should be explicitly stated.

An independent supervisory authority is also necessary. The Cabinet of Ministers should reinforce and reintroduce the Draft Law of Ukraine on Principles of the Natural Gas Market Functioning to bring Ukrainian legislation into full compliance with the provisions of EU gas sector legislation.
       1.  The Cabinet of Ministers should develop and the parliament adopt a Program for Gas Sector Reform to be implemented in 2010-2011 in line with the EU-Ukraine Brussels Declaration. It should aim at restructuring Naftogaz Ukrainy, which should be divided into separate companies specializing in production, transportation, and distribution. Non-core activities should be sold off. Corporate governance should be introduced in the resulting state companies with professional boards consisting of independent directors and public annual reports subject to international audit.
       2.  The Cabinet of Ministers should develop and adopt a Concept for Liberalization of the Gas Market in Ukraine, which should lead to the adoption by parliament of a Law on Principles of the Natural Gas Market Functioning to establish the principles for the natural gas market so that it performs transparently and efficiently, and stimulate competition. These principles should harmonize Ukrainian legislation with EU gas directives.

            This law should ensure legal and organizational independence of the gas transmission operators and prohibit cross-subsidization. The operation of underground gas storage should be separate from gas transportation. All enterprises should be guaranteed non-discriminatory and transparent commercial access to the gas transmission systems and storage. The gas supply and distribution functions should be unbundled.
       3.  The National Energy Regulatory Commission should propose and the parliament adopt laws and regulations for the Ukrainian natural gas market. They should include a Gas Network Code with rules for access to gas pipelines and underground storage, and so on, in line with Ukraine’s commitments as a party to the Energy Charter Treaty and its Transit Protocol.
       4.  In line with the EU-Ukraine Brussels Declaration, the government should develop a plan for the renovation and modernization of the gas transit system and attract financing from interested international financial institutions.
Electricity Reform
Ukraine undertook quite far-reaching structural reforms in the electricity sector in the mid-1990s. The power companies were restructured so that a handful of generating companies were created, while each region basically had its own distribution company. A public wholesale market was organized. The problem, however, was that electricity tariffs were controlled by the state at a level that was lower than the recovery cost, and then the wholesale market could not function well.

The largely state-owned generating companies make chronic losses and cannot generate any profits for the maintenance and modernization of existing electricity generation or the grid, which threatens stable supply of electric power to consumers. Nor do these conditions offer any incentive to increase efficiency. The whole power sector suffers from excessive wear and tear on equipment.

Excessive price control and growing cross-subsidization. The main problem in the power sector is low, regulated electricity tariffs. An evolving malpractice is to differentiate tariffs by category of consumers, with low tariffs offered to households. These privileges are being financed through cross-subsidies, as industry pays much higher tariffs. The growing number and volume of privileges increases cross-subsidization.

Impeded Wholesale Electric Energy Market Reform. In 2002, the Cabinet of Ministers adopted a Concept for the Ukrainian Wholesale Electric Energy Market, but it could not be implemented because of low state-controlled prices. Increasing cross-subsidization complicates any market development. As a consequence, administrative regulation is increasingly needed for the allocation of electricity. Not surprisingly, the extension of administrative allocation has been accompanied by increasing arrears and indebtedness of power companies.

The government presented a Draft Law on Amending the Law on Electric Power Industry’ to the parliament in October 2009, which is supposed to be based on the Concept for the Ukrainian Wholesale Electricity Market. It envisages a new electricity market model used in some EU countries with common rules for domestic electricity markets.

However, the draft law differs substantially from the adopted Concept and lacks many of its components. Its lack of provisions necessitates many regulatory acts, which preferably should be inscribed into law to offer clarity and permanence. The Cabinet of Ministers ought to submit a new version of the Draft Law on Amending the Law of Ukraine on Electric Power Industry with all the key elements of the already adopted Concept.
       1.  A functioning wholesale market should be developed by drafting and adopting a Law on Principles of the Wholesale Electricity Market. The draft law should be based on the Concept for the Ukrainian Wholesale Electric Energy Market Functioning and Development (approved by the Cabinet of Ministers on November 16, 2002) and the Action Plan for the Implementation of the Concept for the Ukrainian Wholesale Electric Energy Market Functioning and Development (approved by the Cabinet of Ministers on November 28, 2007).
       2.  Privatization of the remaining state-owned electricity generating companies and the regional power distributors should form an important part of the state privatization program. The remaining state-owned power companies and mines should be sold off before the end of 2011. These companies can be easily sold off, as prior privatizations show. Preferably, they should be sold to strategic investors.
Coal Mining Reform: Easy and Beneficial
Ukraine has a viable coal industry, but it has never seen any real reform. However, some coal mines have been privatized sporadically, and private coal mines have expanded their production, while the state-owned ones have shrunk. At present, private enterprises dominates the coal sector. Yet prices remain regulated at too low a level.

Coal products are priced on the basis of regulatory acts, not market forces. As compensation for low prices, the state pays all coal mines non-transparent and highly varied subsidies, depending on how much they bargain. Neither the distortion of coal prices nor the extensive state subsidies can be justified, as they do not encourage coal producers to produce more and become more effective.

Ukraine’s policy on coal mining has led to most unsatisfactory financial and economic performance. Discretionary state regulation and excessive state ownership are holding back the industry. Coal production has been stagnant. Labor productivity is low and falling, while costs are rising, and some very inefficient mines continue operating. Losses are large and rising, while payment discipline is poor.

Many Ukrainian coal mines are suffering from poor safety standards causing the death of many coal miners. Subsidies have increased every year. This is the result of wrong priorities, non-transparency, absence of clear guidance for state support, and the abandoning of basic principles of restructuring.

The main goal of coal sector reform must be a cardinal increase in efficiency. The main tasks of reorganization are: meeting the national economy’s needs for domestic coal; cost-effective and secure operation of coal-mining enterprises; and social and economic stability in coal-mining regions. The best way of doing all this is by privatizing and introducing a competitive coal market.

Ukraine can follow the successful Russian coal reform of 1998-99 that was spearheaded by the World Bank. The pillars of reform are privatization of the remaining public coal mines; liberalization of coal prices; simultaneous elimination of coal subsidies; and social support for restructuring. The private Russian coal industry has thrived for a decade after these reforms, developing a vibrant coal market, steadily expanding production, and generating substantial profits.
The Cabinet of Ministers should launch a comprehensive coal industry reform consisting of the following five elements.

       [1] First, the government should draft and the parliament adopt a Law on State Assistance to the Coal Mining Industry, which should conform subsidies to the terms and conditions common in the EU. Subsidies to the coal industry should be phased out gradually as coal prices are liberalized and chronically loss-making mines closed.

       [2]  Second, coal prices should be liberalized.

       [3] Third, the government and parliament should also adopt a Law on the Closure of Mining Enterprises, setting the rules for their closure and measures to mitigate the social consequences. The government should start selecting coal mines for privatization or closure.

       [4] Fourth, a Law on Principles of the Coal Market Functioning should establish the rules for a regular market for coal (after price liberalization) and set up an exchange market for the sale of coal products, as well as a direct purchase and sale contract market.

       [5] Fifth, the privatization of coal mines should form an important part of the state privatization program, and the remaining state-owned coal mines should be sold off.