Carlos Pascual: Key points of Ukraine energy market reform

Carlos Pascual: Key points of Ukraine energy market reform

 Question 1: At their recent meeting in Japan the G7 energy ministers released a Progress Report which outlines key policy measures and priority areas to overcome Ukraine's energy vulnerability, including implementation of the EU Third Energy Package, establishing an independent energy authority etc. How is Ukraine doing in terms of implementing the energy market reform and meeting the EU requirements?


Ukraine’s energy sector has been in a state of crisis since independence in 1991. The G7 Progress Report addressed six priority areas for reform: 1) dependency on Russia for energy imports; 2) inefficient energy systems; 3) developing domestic energy production potential; 4) reducing political risks; 5) market reforms; and 6) renovation and replacement of energy infrastructure. It would be unrealistic after 25 years of struggling with these issues for Ukraine to address all of these challenges in the last two years. Ukraine should receive credit for significant accomplishments. As one would expect, many challenges remain.


Since Ukraine’s Cabinet of Ministers approved a comprehensive “Plan for Implementation of Gas Sector Reform” and since the Rada adopted the new law “On the Natural Gas Market,” Ukraine has initiated positive and, in some case, extraordinary changes. Several key measures include:


a. Ukraine has significantly diversified gas imports. In 2013, Ukraine imported 57% of its gas, and Russian imports accounted for 51% of its gas consumption. In 2015, Ukraine imported 45% of its gas, and Russian imports accounted for 18% of consumption. Ukraine is now importing gas via Poland, Hungary and Slovakia as well as Russia. Naftogaz is no longer the sole importer – a number of new private importers including big industrial gas consumers, private traders, and private gas producers now import gas to Ukraine. In 2015, imports from Europe accounted for 28% of Ukraine’s gas consumption, but a large portion of these imports originated in Russia. Still, with Europe increasingly inter-connected with gas pipelines and new LNG and pipeline import options to Europe, Ukraine has positioned itself to diversify further its imports, thus moving itself toward deciding on the source of gas imports based on competitiveness rather than necessity.


b. Legislation passed in December 2015 reduced gas royalties effective 1 January 2016 for private and state companies, improving by the incentives for private production. For wells deeper than 5,000 meters, royalties decreased from 55% or 70% depending on the producer to 29%, and for wells shallower than 5,000 from 28% to 14%. My company, IHS, established that production costs incurred by private Ukrainian producers were in line with eight peer countries with comparable fields, and that reduced royalties were needed to allow Ukraine to offer competitive returns in a world where investment dollars are highly fungible. The December 2015 legislation returned Ukraine to a status quo position prior to August 2014, when draconian tax hikes were introduced that disincentivized local companies to increase gas production, in turn increasing Ukraine’s dependence on gas purchases from Russia. Taxes on oil and condensate remained unchanged.


c. Domestic gas prices for households and district heating were liberalized to market levels in May 2016, eliminating differentials between industrial and residential consumers that could incentivize corruption. The law “On the Natural Gas Market” decontrolled industrial natural gas prices on October 1, 2015; suppliers now compete and charge industrial consumers what the market will bear. Industrial customers are now free to choose gas suppliers. Because industry previously paid more for gas than residential consumers, there were incentives to divert illegally subsidized residential gas to make windfall profits in the industrial market, while low residential prices created few incentives for efficiency.


d. In a politically charged environment between Russia and Ukraine, Ukraine has not diverted Russian gas supplies intended for Europe. The G7 commented in its report that “despite the far more serious overall context of the relationship with Russia, Ukraine has managed to separate this bilateral factor from the transits by complying with transit contract conditions and the relevant provisions of the Energy Charter treaty and did a credible effort to act as a reliable transit partner to Europe.”


The G7 report encouraged the Ukrainian government to “continue and complete energy market reforms, including further increases in gas, electricity and other fuel prices, installation of gas and electricity meters at buildings and household levels, gradual abolishment of subsidy, and enactment of the secondary legislation to carry out liberalization of gas and electricity markets.” Key items include:


a. Restructure or eliminate several new rules that complicate and significantly increase the cost of doing business for private players, for example: adoption of in-kind gas stock reserves for all gas suppliers including gas producers in the amount of 50% of the planned monthly sales volume, financial guarantees to Ukrtransgas for pipeline capacity usage (20% of the value of gas to be transported in a given month) and storage (100% prepayment), as well as foreign currency restrictions.


b. Move to a profit-based taxation regime for upstream production that better captures project economics and would offer flexibility in the face of significant changes in gas prices. For hard to recover (e.g. unconventional) resources, special incentives will also be essential. Oil and condensate royalties are still extremely high relative to impact on attracting investment into the sector.


c. Adopt the law on the independent status of the regulator (the National Energy and Public Utilities Regulatory Commission). A new draft law on the Regulator passed the first reading at the Rada in mid-April. This draft law contains important changes, including a new transparent system of election and then rotation of the members of the Regulator on a competitive basis, as well as obligatory publication of all the Regulator’s resolutions and of public commentary and suggestions.


d. Agree upon and implement a model to unbundle upstream production, transit and other assets. The Ukrainian government, donors and Naftogaz could not reach agreement by the original deadline of February 2016.


Overall, Ukraine has moved closer to more competitive and liberalized gas market. The scale of reforms pending since independence is daunting. As the G7 has stressed, however, much critical work remains to be done to continue improving regulations, provide appropriate incentives for production and efficiency, and ensure that the “rules of the game” are equal to all market participants.


Question 2: Ukraine's government in April fixed a new ceiling on gas prices for households. The respective decree proscribes a formula similar to the one used on the NetConnect Germany (NCG) hub. It will help defeat corruption and stimulate energy efficiency measures in Ukraine. What recommendations would you make on this issue?


The Ukrainian government had previously established a price schedule for Ukraine’s residential gas sector, in line with its IMF program, to liberalize prices fully by mid-2017. The new Ukrainian Government under Prime Minister Vladimir Groysman accelerated this liberalization starting from 1 May 2016, in effect increasing the price for household by about 66% and the price for district heating consumers by almost 120% in hryvnia on annual basis. Such reforms are never easy, but they have the benefit of being taken when European and international prices are low due to increased supply on international markets, and increased capacity in Europe to import and transit gas across the continent. Residential and municipal consumers will not pay higher prices in 2016 than they would have paid, for example, in 2012 in dollar terms.


There are additional important and far-reaching consequences of the domestic residential price reform. First, Naftogaz will stabilize its financial situation as it will no longer have to cover the difference in price between imported gas and gas supplied to subsidized sectors at much lower prices. Second, market prices for all sectors kill opportunities for arbitrage when cheap gas for subsidized sectors could be sold to high-value industrial consumers. Finally, market prices give real incentives to economize on gas use and further improve the domestic gas balance.


Question 3: In the light of the decision to raise gas and heating prices for households, subsidies for unprotected population groups are crucial. Subsidies, however, are not always designed to increase energy efficiency, and may be related to corrupt schemes as well. How do you view the present subsidy payment system in Ukraine? How it could be improved? What should be changed? Is subsidy monetization necessary?


There is a growing body of international experience on how to balance most effectively the elimination of energy subsidies, to encourage efficient use of resources and avoid price distortions that can encourage corruption, with the social objective of protecting vulnerable households that cannot afford to pay market prices. International consensus has emerged that targeted subsidies to low-income consumers are far preferable to general price subsidies, as they state’s limit the fiscal burden to supporting low-income households while eliminating subsidies to higher-income consumers who can afford to pay market prices. In Ukraine, subsidized gas prices for residential and municipal consumers deterred the introduction of public financing mechanisms such as municipal bonds that could have significantly accelerated investments in energy efficiency. As a result, Ukraine continues to have one of the most energy intensive economies in Europe, reducing economic competitiveness and imposing a high fiscal burden on the federal budget. Market level prices for both consumers and producers foster incentives to improve consumption efficiency and production growth.


A switch from price subsidies to monetization of subsidies -- targeted state transfers to socially “vulnerable” gas consumers -- represents a very positive move towards a sustainable balance between market efficiency and social protection. Targeted support is more difficult to obtain, as it requires consumers to establish their eligibility with a designated agency of social protection. Verification of subsidy eligibility should occur annually. Yet potential corruption schemes still exist (for example understatement of personal income), which will require carefully considered audit procedures and penalties that encourage honesty, without imposing such a bureaucratic burden that the government cannot implement them. This balance of checks and balances with bureaucratic feasibility has been one of the hardest elements globally for states to achieve in their subsidy programs.


Question 4: The National Commission for Energy, Housing and Utilities Services Regulation has approved a new system for calculating electric power generated by thermal power plants. This system takes into account a coal price in Rotterdam. Do you view this approach favorably? Would this help make the market more transparent? What would you recommend?


The Rotterdam coal price is the only audited market price available in the European sector, and in that sense would be an acceptable guide to price movements. However, care should be taken to make sure that the mechanism used to link Ukraine’s market to the Rotterdam coal price is equally open and auditable. In addition, it should be remembered that the international steam coal market is an openly traded one which is currently at close to all-time lows. Furthermore, international coal prices have traded at levels between four and five times t he current level in the past, so there is clearly a risk that hitching Ukrainian prices to those in the international market brings a substantial risk of price inflation unless safeguards are built into the new system.


Senior Vice President, Global Energy


Carlos Pascual, former senior US diplomat and most recently the State Department’s top energy official, joined IHS in January 2015 as Senior Vice President to focus on global energy issues and international affairs. Mr. Pascual has been leading ongoing IHS work on Mexico’s energy reforms and the implications of the Iran nuclear deal for energy development and sanctions policy. He has also led a project on developing a competitive fiscal regime for Ukraine’s natural gas sector. He is centrally involved in incorporating geopolitical risk into IHS market forecasts.


Mr. Pascual was previously US Ambassador to both Mexico and Ukraine and was Special Assistant to the US president for Russia, Ukraine, and Eurasia on the National Security Council.


David Price, Senior Director of the IHS Global Steam Coal Advisory Service.


He is also editor of IHS Steam Coal Forecaster and Coal UK. Mr. Price has been the author and lead editor of many special reports while also speaking at conferences and conducting investor briefings around the world. He has taken the lead on coal insight during the development of the IHS global energy scenarios. In 2010, Mr. Price took responsibility for the launch of the IHS Global Steam Coal Advisory Service, which is now one of IHS Energy's flagship services.


Anna Galtsova, Senior Principal Researcher in the Russian and Caspian Energy team


Anna focuses on the analysis of broad trends and issues in the energy sector of former Soviet Union countries, as well as project economics. Anna participated in a number of strategy planning projects for Russian and international oil and gas majors as wells as for the Ministry of Energy of Russia and the Ministry of Energy of Ukraine. Anna regularly takes part in oil and gas round tables and conferences including Eurasia Transportation Forum, Astana Economic Forum and others.









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