Reforming Ukraine's Gas Market Takes Political Will: Research

Over the past few years, Ukraine has made much progress in liberalising its gas market, including cutting subsidies and developing network codes along European Union lines. 

With the war with Russia in the east spurring it on, the country has made an effort to find alternative suppliers in the west, freeing it from Russian gas so far this year. State monopoly Naftogaz Ukrainy has also introduced the liberalising policies of the EU's Third Energy Package, pushing for the unbundling of transmission from supply and production. 

But it has started from a very low base and a new research paper published by the Oxford Institute of Energy Studies – The Ukrainian residential gas sector: a market untapped – advises that there is still a lot to be done before investors will pile in.

Retail prices for the domestic sector need to go up before energy efficiency will improve and demand come down, the authors argue. And there remain a lot of uncertainties, including the strength of political will to raise prices and sell off strategically important infrastructure, that could slow reform down or even turn the clock back.

“Many former post-Soviet states have similar issues as Ukraine with subsidised energy prices, leading to low energy efficiency, high costs for the state budget and less profitable domestic gas extraction. Reformers should take advantage of the currently very low international prices for natural gas by decreasing or removing price subsidies, while also introducing efforts to increase energy efficiency. The framework presented in this paper for calculating the effects on the size of the gas market could be used by policy makers seeking to evaluate the effects of a whole or partial subsidy removal of natural gas,” they say.

The largest inefficiencies result from large energy losses during the production and distribution of hot water by the district heating companies (DHCs), with an estimated 59% of the total energy lost. A comparable number for German DHCs is 32%, they say.

Energy security: Ukraine has more storage capacity than any other country (Credit: Naftogaz Ukrainy)

Additionally, the corporate governance reforms of Naftogaz and its subsidiaries will play an important role in creating a stable and non-corrupt Ukrainian business environment for natural gas. Further on, the pipeline system might be partly sold off, bringing in useful revenue – although the country’s role as a major transit route from the east appears to be ending, with Gazprom planning to retain about 20bn m³/yr of entry capacity against exit capacity of 150bn m³/yr. The authors doubt if western investors will be quick to bid for a minority stake in this asset, were it to come to market.

Major problems are corporate governance and regulation. A transparent, reformed Naftogaz with better corporate governance practices, subject to independent and professional oversight might be able to overcome the historical deficiencies of the company and root out malpractices as well as allow the company to become profitable in the long term, the authors say. “Naftogaz seems serious about the corporate governance reform of the company and the pressure from international organisations such as the EBRD has been very strong, so there is a decent chance that Naftogaz will start acting more like a modern corporation in the coming years,” they say.

Ukraine's energy regulator NCEPUR is in a worse position: “according to the Third Energy Package, this entity needs to be fully independent from the government and act as a neutral arbiter of the gas market. As of April 2016, the necessary changes in legislation are not yet passed. Currently, the legal foundation of NCEPUR is unclear, with the president still having the legal power to establish and liquidate the body at will, a right which has twice previously been used to dismiss NCEPUR's management,” they say.

As import prices increase in the future, NCEPUR may fail to adjust the domestic prices accordingly. Similarly, with possibly increasing rates of non-payment among consumers due to the recent subsidy removal, the public pressure to decrease prices could also rise.

There has also been an opaque arbitrage opportunity owing to the parallel existence of two markets: subsidised household gas, supplied by state UkrGazVydobuvannya (UGV); and industry, which pays a market price that has been ten times greater. “Having a system with very low levels of metering of gas consumption, until recently the case in Ukraine, makes it easier to get away with these practices,” they write. However, the low prices are responsible for the continuing stagnation of UGV.

In 2014 households (including district heating companies) consumed 22.1bn m³ of natural gas, out of which 13.9bn m³ came from UGV, which had to sell it at subsidized prices to Naftogaz, and 8.2bn m³ came from imports.

And past irregularities cast a shadow over the present as well. During the privatization of gas distribution companies [oblgazy] in 2012, Gaztek, the company owned by businessman Dmytro Firtash – who is now exiled – won 14 out of 17 bids, allegedly acquiring the regional gas companies for prices far below market rates, often without real competition. The authors say that Firtash's business group “controls some 70% of the Ukrainian gas distribution market. In essence, a state-monopoly has been exchanged for an almost private monopoly.”

William Powell