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23 April, 2015  ▪  Oles Oleksiyenko

Free Energy and Its Enemies

What reforms are going on in Ukraine’s energy sector and what is their outlook?

It’s been high time to reform Ukraine’s energy sector for years now, given that its stagnant state in a post-soviet society was possibly one of the biggest factors halting economic and social transformations, making the country vulnerable to external blackmail and dragging it into a pit of indebtedness. The country’s politicians used populist slogans to prevent the transition to a normal market environment in the energy sector—and continue to do so to this day. The resulting many-phased system for calculating rates, cross subsidization, complete lack of transparency, and monopolist production, transportation and sale of various kinds of energy made the electricity market a virtual Klondike for siphoning off public funds, that is, taxpayer money, into private hands.

Roadmap to reforms

In the coalition agreement hammered out at the end of 2014, reforms in the power industry were given an entire chapter of their own. There was supposed to be “liberalization and the transition to a single principle for market pricing for gas and power in order to provide incentives for conservation.” At the time, the ruling coalition committed itself to ensuring the necessary conditions to attract investment to undertake structural modernization in the power industry, upgrade its infrastructure, and expand domestic production of natural gas, petroleum and coal.

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Nevertheless, since reforms were the result of circumstantial and external pressures, especially from the IMF, they continue to stumble over both open and hidden resistance among the oligarchs and officials who are keen to preserve the existing corrupt mechanisms. So they are taking place very slowly and inconsistently, and the loopholes that foster abuse remain in place.

Now it’s become evident that the deadlines outlined in the coalition agreement will not even come close to being upheld. For instance, the harmonization of the regulatory environment governing the gas and power markets in Ukraine was supposed to have been brought in line with the norms of the Third Energy Package in Q1 2015. At the moment, this is more likely to happen in the gas market, since the related bill passed first reading in March and is likely to be approved altogether shortly. The prospects of bringing the power industry in line with the Third Package any time soon are much less clear.

On March 31, Presidential Deputy Chief-of-Staff Dmytro Shymkiv commented on the prospects for comprehensive reforms in the sector, saying that work to reform the power industry in Ukraine was only supposed to be completed on June 12. Apparently, “all the top priorities, first drafts and preliminary concepts will be established in the various areas of the sector by April 10, while interim results, an evaluation and modeling related to energy conservation, rates” and more would be completed by April 30.

By April 10, the Ministry of Energy and Coal was supposed to draft and submit to the Cabinet: (1) a draft sectoral program for reforming the coal industry; (2) a draft targeted economic program for developing the atomic energy complex of Ukraine for 2015-2019; (3) a bill “On mandatory separation of activities in the power industry; and (4) a bill on amending the Law of Ukraine “On the basis for the functioning of the electricity market in Ukraine” to reflect the propositions of the Secretariat of the European Energy Community.

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What’s in a market rate?

The current government should be given credit for one thing: despite the extremely difficult socio-political situation in the country, it has nevertheless had the courage to take on the task of bringing rates for various categories of consumers to market levels, a long-overdue and extremely vital challenge for the future health of the domestic power industry. Natural gas rates have been raised to UAH 7.19/cu m for nearly all categories, a threefold increase for household users and a slight reduction for industrial ones. This step has eliminated the need to finance illegal income for the oblgases, the oblast gas companies, as previously they would sell discounted gas intended for households to commercial customers at considerably higher prices.

However, one potentially abusive exception has remained in the form of discounted rates for gas for the community cogeneration sector. As of April 1, their rate will be only UAH 3.00/cu m, which means that this gas could be sold to other user groups for the much higher UAH 7.19 rate. What’s more, because discounted rates were maintained for cogeneration customers and the “minimal use” 200 cu m/month for households during the heating season, Naftogaz is faced with a deficit, albeit a much smaller one, which has been estimated at US $3-4 billion for 2015—compared to US $8.0bn in 2014.

But the current government did not find enough political will to take the same kind of decisive steps on the electricity market that they took on the gas market.

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First of all, the reduced—and potentially abusive—rate for household consumers for 100-600 kWh per month has been maintained. How much any given consumer actually uses—100, 200, 400 or 500 kWh—is something only the utility company—and customers with a household meter—knows. In this way, private oblenergos, the oblast power companies, can continue to sell electricity that supposedly was used by the category of consumers, whose rate as of April 1 is UAH 0.63/kWh, for UAH 1.407 to those consumers who use more than 600 kWh a month.

Secondly, it will take two years to bring rates in to the level at which they are commercially justified, which will have a negative impact on Ukraine’s power industry and its capacity to diversify sources of fuel supplies or carry out necessary modernization.

Given the threefold devaluation of the hryvnia that has taken place this past year, in dollar terms, the rate increases will still be no more than 15% above 2013 rates by 2017. And even that will only be on condition that the hryvnia exchange rate remains at current levels. Despite the April hike, electricity rates in Ukraine are currently not only not higher in dollar terms, they are actually 2-2.5 times lower than they were in 2013. Meanwhile, prices for all kinds of fuels, from fuel rods to gas and a large portion of coal, as well as the costs for much-needed upgrades to the sector are all in dollars.

The situation with prices for domestic gas is even worse. For Ukrgazvydobuvannia, the state extraction company, the sale price was increased only to UAH 1,500 or US $68/1,000 cu m, which is several times cheaper than imported gas. At this rate, domestic extraction is unlikely to sharply increase in order to cover domestic needs and improve national energy security. And so Ukraine will continue to have to buy expensive natural gas from abroad.

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The reforms to the system of subsidies have also been poorly designed. Understandably, in simplifying the provision of subsidies maximally, the government was trying to reduce the level of public dissatisfaction and the threat that there would be massive non-payment at the new rates. Still, the way it looks now, the principle for subsidies provides no incentive whatsoever to conserve energy, whether gas or electricity, to become more energy efficient, or to insulate residential buildings, although the reverse should have been true.

Not only is the provision of subsidies not related to how efficiently or wastefully the customer uses heat, but worse yet, if the household decides to insulate its residence more effectively, its monthly heating bill will not go down—the size of the subsidy will! A similar situation exists with the use of electricity: given the current conditions for getting subsidies, there’s no incentive to install energy-efficient household appliances or light bulbs to replace energy inefficient ones. Indeed, under certain circumstances, even the owner of several apartments who is earning income from renting them can qualify for a subsidy, while individuals who spent more than UAH 50,000 the last year, on insulation of their homes among other things, cannot.

By steeply increasing access to subsidies without establishing proper criteria for receiving them, the Government is risking that it will actually spur the consumption of natural gas and power compared to last year. And so, the entire burden for paying the higher rates will end up falling on the state budget.

Diversify and demonopolize

One major achievement after the Yanukovych regime collapsed last year was serious diversification of suppliers of imported primary energy, primarily gas, although this was also critical for coal. For instance, of the 480,000 t of coal imported over January-February 2015 for the country’s cogeneration and power plants, only 25% was Russian coal, while the rest came from South Africa, Poland and other countries. In Q1 2015, only 2.16bn cu m of the 5.8bn cu m imported came from Russia, while 3.65bn cu m came from the EU, causing Gazprom’s share to fall to 37%. Despite an agreement reached with the Russian Federation about a 100% discount on gas in Q2 2015, Energy Minister Volodymyr Demchyshyn said the country would continue to import fuel from the EU based on existing contracts. Meanwhile, the bill “On the gas market” currently being prepared for approval limits the market share of any one source of imported natural gas to no more than 30%.

Back in May 2014, Ukraine joined the Aggregate Gas Storage Inventory transparency platform of Gas Storage Europe, while in June the Cabinet decided to reform NAK Naftogaz Ukrainy. The proposition is to spin off a couple of stock companies: Ukrainian Gas Transport System (UGTS), and Ukrainian Gas Storage Tanks (UGST). According to the coalition agreement, by the end of 2015, Naftogaz Ukrainy is to be comprehensively restructured, a GTS operator certified, in order to separate the extraction, transport, delivery and storage of natural gas, and to ensure transparent, and uninterrupted access to gas transport infrastructure.

On March 5, 2015, the Verkhovna Rada passed first reading of a bill “On the natural gas market,” which is likely to pass into law shortly. If this bill is, in fact, passed in April, it will come into effect on October 1, and by June 1, 2016, the GTS operator will be completely separate from delivery operations, that is Naftogaz.

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According to this bill, the natural gas market will function on the basis of free and honest competition, the principle of a high degree of protection for consumer rights and interests, the free selection of a provider, equal rights to engage in foreign trade involving the purchase and sale of natural gas, noninterference in the market on the part of the state other than in cases when this might be necessary to protect national interests, and guarantees of equal access to the Gas Systems Ukraine. Prices on the wholesale and retail markets will be calculated to reflect the energy value of natural gas. Once a consumer gives notice that they intend to change providers, the switch will have to be completed within three weeks from that date.

Simultaneously with legislative reforms in the gas sector, the efforts of the Cabinet of Ministers to return control over the distribution pipelines to the state company will play a major role in the sector’s liberalization. In 2012, the Azarov Government effectively handed over control of these pipelines to oblast gas companies or oblgases, most of which are controlled by companies belonging to Dmytro Firtash.

In the power sector, the coalition agreement stated that the transmission and distribution of electricity would also be separated from other functions of power companies operating on the same market by 2016. But, nearly equally importantly, a Power Network Code is supposed to come into effect by July 2015. For electricity consumers, this is critical because it eliminates the “Rules for Electrical Hook-up” that are currently in effect and replaces them with new ones that will offer consumers far more rights and, hopefully, put an end to corruption.

Reforms to the power market are likely to face resistance from Rinat Akhmetov’s DTEK and several major shareholders among Ukraine’s oblast power companies or oblenergos, which are likely to lose their current monopolist status on this market.

Wanted: A Maggie for the miners

The most complicated and difficult reform will be restructuring the coal industry. The coalition agreements calls for all mining companies to be privatized over 2015-2016 and for all mines that are not sold to either be shut down or mothballed by 2019. By Q2 2015, state assistance for the upgrading or re-equipping of old mines and the building of new mines or mines under lease or concession was supposed to have been prohibited. Starting in Q2 2015, the coal industry was to be liberalized, complete with an exchange for trading in coal based on electronic trading so that the industry could switch to market pricing for heating coal, a transition to direct purchase contracts, and the closing of Vuhillia Ukrainy, the state coal company.

Not long ago, Minister Demchyshyn announced that Vuhillia Ukrainy would be declared bankrupt shortly and shut down, so that mines and mining associations would be able to sell coal directly to customers. The Cabinet’s Action Program calls for the privatization of 37 mines, the mothballing of 24, and the closure of 32 unprofitable mines over 2015-2019. So far, the Cabinet has approved the list of mines slated for privatization in 2015: the Novovolynsk Mining Management unit belonging to the VolynVuhillia state company; the Pivdennodonbaska Mine #3; the Dmytrova Mine belonging to KrasnoarmiyskVuhillia; separate units of LvivVuhillia; and others. A 16.5% stake in the privately-owned Zasiadko Mine, one of the most accident-prone in Ukraine, will also be sold.

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Despite public statements by the Energy Minister, Volodymyr Demchyshyn that the previously agreed rates for power and prices for domestically mined coal were appropriate, he appears to have been forced to make concessions under pressure from DTEK. Based on Q1 2015 results, the rate for power supplied by TESs was raised nearly 40%. According to some sources, the price of the gas group’s coal used to generate power will also be raised, to UAH 1,500/tonne. Meanwhile, MinEnergo has begun sending out signals that there could be a partial return to subsidies for the state extraction of coal, which suggests that reforms in this troubled sector are now in limbo.However, the cessation of subsidies for coal extraction in 2015 and preparations for the closure of mines has predictably run into resistance from miners and the de facto owners of state mines. Mining unions threatened widespread protests and even a takeover of the government in Kyiv if the government did not change its stance on the industry. The situation was undermined further by active efforts along similar lines by Akhmetov’s DTEK, which, as the owner of many mines and of the main consumers of coal in the country—cogeneration plants—began to fight to steeply increased prices for its coal and for the power generated by DTEK’s TESs.

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