Reforming the gas sector remains one of the most crucial pre-requisites to achieving a genuine political transformation in Ukraine. The gas sector has been notorious for its corruption schemes, widely used by the Ukrainian political elites in the past. In 2015-2016, a number of reforms were introduced by the government in exchange for international loans. Since 2017 the reform pace has stalled, as vested interests are not keen to lose control of a lucrative business sector.
New sources and higher prices
In line with the EU´s Third Energy Package, Ukraine complied with proposed reforms to provide the unbundling (separating transmission from other gas services such as production and supply) of Naftogas, the state-owned oil and gas monopoly, and liberalize the national gas market.
For the first time in 2016, Ukraine did not import any gas from Russia. Being previously highly dependent on Russian gas, Ukraine managed to diversify its routes and sources, mainly via reverse gas flow from Slovakia, Poland and Hungary. By reducing the amount of import gas significantly, the bills were cut from $12 billion in 2009 to $2 billion in 2017.
To reflect the market prices, the government introduced subsequent price hikes for individual households – 200-300% in some cases – to offset the high price of import gas. Over two and a half years, the gas tariff was hiked nearly ten times, resulting in high household bills. To cushion the drastic increase, the government overhauled the system of energy subsidies for poor households. The increase in prices has been a longstanding requirement from the IMF to enhance Naftogas´ financial standing and to improve energy efficiency in the sector.
Management reform of Naftogas
In May 2016, a management reform of Naftogas was launched. A new supervisory board was created for the first time, including three foreign professionals from the UK. Aimed at restructuring Naftogas, the supervisory board approved a gas sector reform plan and developed a new model of corporate governance. The fact that Naftogas, the country´s largest taxpayer, was never profitable points out the scale of corruption in the sector – $2-3 billion is estimated to have been siphoned each year. In 2014, Naftogas ended up with a deficit of 106.6 billion hryvnyas ($8.2 billion), which constituted about 6.7% of the country´s GDP. Due to its new effective corporate model, the company ran profit of $1 billion in 2016 for the first time in its history. Similarly, in 2017, Naftogas recorded profits which accounted for 16% of Ukraine´s GDP.
Naftogas vs. Gazprom
In December 2017, Naftogas won a dispute with Gazprom in the Stockholm Arbitration Court. The court threw out Gazprom´s claim that Naftogas has to pay $56 billion in line with the so-called “take or pay” gas clause. Under this approach, Gazprom obliged any party to pay for gas even if it was unused. The court also reduced the gas price for the 2nd quarter of 2014, linking it to market prices instead of the price of oil. Finally, the court allowed Ukraine to re-export Russian gas, which was previously impossible under Gazprom´s contract conditions.
In 2017, however, reform progress was stalled by presidential forces and vested interests. In March, the government ordered the prescribed amount of gas to be delivered to regional gas distribution companies at a fixed price. 70% of the regional gas distribution companies are controlled by Dmytro Firtash, an oligarch who is currently under arrest in Vienna facing corruption charges. To bypass the new requirement separating transmission from production and supply activities, shell companies were created. This breach of the unbundling commitment was strongly criticized by Naftogas, the World Bank and the Energy Community.
At the same time, the Ukrainian government tried to undermine the independence of Naftogas´ management. The decision was made to expand the supervisory board from five to seven members, thus leaving the international members in the minority. As a result of this political meddling in the reform process, in August and September the three foreign professionals resigned. As it would jeopardize the political survival of the current political elites, the independence of Naftogas´ management and its planned process of unbundling met strong opposition. Later, the government changed the process, by canceling open selection of the supervisory board members. The supervisory board was then reshuffled to include four foreign and three Ukrainian professionals from the energy sector.
What to watch in 2018
Domestically, numerous secondary acts will need to be adopted, such as Law on the Cabinet of Ministers, Law on Pipeline Transport, and Law on Oil and Gas, which would allow the full implementation of the Natural Gas Market Law and the proper unbundling of Naftogas.
The process of unbundling is crucial to the reform of the entire gas sector. This is strongly influenced by pro-presidential forces that try to meddle in the separation of Ukrgazvydobuvannya and Ukrtransgas from Naftogas. The former two companies are the most profitable branches of the state-owned monopoly. The failure to unbundle them will endanger the whole process of gas sector reform in Ukraine and will block the restructuring of related sectors. The continuous battle between the Ukrainian government and Naftogas needs to be followed closely.
The ruling on the second dispute in Stockholm on the transit contract case (due on 28 February) will be a pivotal moment, as the planned unbundling is supposed to start after the court´s decision. The transfer of Ukrtransgaz´ assets to the newly created transmission system operator is planned to take place within 30 days after the Stockholm tribunal´s verdict.
Finally, Ukraine´s decision to cooperate with Poland and Lithuania to build cross-border interconnections could strengthen the country´s energy supply security. In a similar vein, planned participation in the development of Croatia´s LNG terminal would be beneficial for Ukraine´s energy diversification.
Maria Shagina is an Analyst at Global Risk Insights. She holds a double PhD degree from the University of Lucerne and University of Zurich and a M.A. from the University of Dusseldorf. As originally appears at: https://globalriskinsights.com/2018/01/gas-sector-reform-ukraine/
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