Gas Market Reforms in Ukraine Lead to Energy Independence

Jesús Rodríguez Fernández || CC

The end of February 2018 was marked by the victory celebration at the Ukrainian gas market as Ukrainian Naftogaz won the case on gas transit against the Russian Gazprom at the Stockholm Arbitrage Court. The Gazprom has to pay the Naftogaz USD 4.6 bn for violating the “take or pay” clause. Together with almost USD 2 bn that the Naftogaz owes the Gazprom in the gas case, the Naftogaz net win is USD 2.6 bn. However, already on March 1, 2018, Russia used the same tactic against Ukraine as it did in 2009, namely refusing to supply gas to Ukraine. The Gazprom broke the decision reached in Stockholm on the obligation of the Naftogaz to purchase gas from Gazprom. The country was faced with the shortage of gas as well as reduced pressure in the pipeline used to transit gas to the EU. This time Russia did not reach the effect it created in 2009 and the shortage of gas was felt by Ukraine only for several days.

In 2009, the Naftogaz has signed the agreement with the Gazprom on the unfavourable conditions. ‘Take or pay clause’ for the 52 bcm of gas per year de facto granted the Gazprom the monopoly for the imports of gas. The defined in the agreement price was higher than USD 450. As a result, the Naftogaz in 2014 referred to the Stockholm Arbitrage Court for the renegotiation of the gas transit contract and for the decrease of the gas price in the gas supply contract for USD 30.3 bn. The Gazprom filed counterclaims for the violation of the “take or pay” clause and the gas price for USD 47.1 bn against the Naftogaz. The first decision of the Arbitrage Court on December 22 was about gas supplies: the Court ruled that the Naftogaz has to buy 5 bn cubic meters of gas annually (4 bn cubic meters on the “take or pay” condition) and has to pay the Gazprom for the gas consumed in 2014 at the German gas hub prices. The second Arbitrage ruling was on February 28 about gas transit. According to it, the Naftogaz’ claims for compensation of the decrease in gas transit volumes to Europe were confirmed; however, the gas transit tariff remained unchanged.

These two seemingly unrelated rulings were nevertheless connected as both parties waited for the second ruling to determine a final course of action. The Naftogaz in January started negotiations with Gazprom on the supplementary agreement to the gas contract necessary to start buying gas in March. At the beginning of February, the head of the Naftogaz told in an interview that the agreement was ready to be signed. Other Naftogaz officials confirmed that they held two rounds of negotiations and that there is nothing to discuss with the Gazprom as all the conditions are described in the court ruling and that Gazprom understands the consequences of not signing.i However, the agreement was not signed. Apparently, the Gazprom waited for the second ruling to decide whether it would be profitable for it to follow the law or it would be better to ignore the decisions of the international court. As both rulings are not public, it is hard to say whether there are any penalties for the artificial delays in signing the supplementary agreement. As a result, after the second ruling taken in the favour of the Naftogaz, the Gazprom returned the Naftogaz the prepayment for gas supplies in March and rejected to supply gas to Ukraine. Apart from that, it reduced pressure in the pipe, which made it close to impossible to transit gas to the EU in the contracted volumes. As a result, Ukraine faced the gas shortage in the first two days of March.

In March 2018, the possibility to solve the problem of gas shortages was ensured by changes in the gas market that occurred in the last several years. Ukraine greatly reduced its dependence on Russia as the only gas supplier. It has not purchased any natural gas from Russia since November of 2015. In March 2018, it returned to Russia only to comply with the decision of the Stockholm Arbitrage Court to purchase gas from the Gazprom at 5 bcm per year. In turn, Ukraine developed other supply routes and purchased the gas from the EU. In 2017, it bought 10 bcm from Slovakia, 2.8 bcm from Hungary and 1.3 bcm from Poland. By the beginning of March, Ukraine also had sufficient amounts of natural gas stored in the underground gas storages. Already at the end of March 2, the Naftogaz was able to swiftly contract for additional gas supply from Poland (at 0.06 bcm) and increase the usage of gas from storages. Another change, which helped Ukraine to circumvent the negative impact of the Gazprom’s action, was the decline in gas consumption (from 50.38 bcm in 2013 to 28.4 bcm in 2017). If the weather was not so freezing, the shortage of the gas was unlikely to be so heavily felt on the first day. The all-Ukraine public campaign “turn gas down” asking people to temporarily decrease their gas consumption initiated by the Naftogaz had also its impact on reducing gas consumption in the first day of disruption by 14%.ii

Another component of changes that helped to solve the situation was the changes in roles played by different institutions in the gas market. The Naftogaz is now a strong independent player that can contract other companies for gas supply more easily. As a result, gas supplies are finally an economic issue rather than political contrary to many years before 2013. Apart from that, the Ministry of Energy created a “crisis committee” in the first hours after the Gazprom refused to supply gas to Ukraine to explore possibilities to reduce gas consumption. In particular, the budget entities were suggested to shut down for several days (later this decision was cancelled as the gas shortage problem was solved) and thermal power stations used oil fuel instead of natural gas.

Overall, the relations with the Gazprom do not promise to be easy. It will be hard for the Naftogaz to plan its purchases this year with such an unpredictable partner. Another challenge for Ukraine is created by the chances that the Nord Stream II would be launched in the nearest future. As a result, Ukraine will lose its dominance in the transiting gas from Russia to the EU, which would reduce FX inflow to the country, but also reduce the attractiveness of Ukraine’s gas transporting system for the EU member states.

Therefore, Ukraine should continue gas market reforms to ensure energy safety for the coming years. The measures are expected in several dimensions, primarily, to ensure higher own gas extraction and reduce gas consumption. Ukrainian state-owned gas extracting company Ukrgazvydobuvannya has to increase investments in geological surveys and development of new gas wells as the current wells are either on top of their capacity or nearing exhaustion. To stimulate private gas extraction companies, the Verkhovna Rada in December 2017 decreased the rent for gas extraction for the new wells from 29% to 12% for the wells up to 5 km and from 14% to 6% for the wells deeper than 5 km. These measures should help increase gas supply on the market.

Additionally, the use of alternative energy should be further promoted. In particular, currently, there are already some programs that cover part of financing required to switch to alternative energy sources like pellets, straw, solar or wind energy. Ukraine might also import of liquefied natural gas as the construction of LNG terminals become economically effective investment due to decline in LNG prices.

To decrease gas consumption, Ukraine has to stimulate the population as the biggest gas consumer to save gas. The first step to this is to install gas meters in every residential building. This will help to prevent stealing gas, selling it to the industry at a lower price and will stimulate the population to avoid unnecessary gas consumption. This would require investments in the thermal insulation of the buildings, which requires the effective operation of the Energy Efficiency Fund, which is to be created in 2018. However, to be efficient the Fund requires more financing than currently foreseen for this year (at UAH 1.2 bn). Currently, Ukrainian government tries to stimulate gas savings through offering special programs “warm credits” where the state covers the majority of costs for the installation of energy efficient windows, improving the insulation of buildings. However, allocated for this financing is not sufficient to make a real impact. Besides, the Government has to finally monetize the housing and utility subsidies (HUS) to population, which would create incentives for households to save gas. This step is planned for 2019; however, there are risks of the delay in the implementation of this measure. Meanwhile, the allocated for the HUS UAH 71 bn do not create incentives for gas savings.

Energy market reforms are also needed to keep Ukraine’s gas transportation and storage system attractive for the EU. Ukraine has to fulfill the obligations in the framework of the Third Energy Package of the Energy Community. This includes primarily unbundling of the Naftogaz into three companies: for extracting, transporting and selling of oil and gas. The EU needs the final decision on the unbundling procedure to understand what company will be the contractual partner. In April 2017, the Naftogaz, the Ukrtransgaz, Snam (Italy) and Eustream (Slovakia) signed a memorandum of understanding aimed at jointly evaluating opportunities for collaboration in the operation and enhancement of the gas transport system (GTS) in Ukraine and several other companies expressed their interest to join. The EU is interested in ensuring further transit of gas via Ukraine and in further usage of its underground storage facilities but needs certainty about transit mechanismsiii.

To sum up, Ukraine has launched gas market reform. It has led to higher energy independence and facilitated faster decision making during shocks at the gas market. However, the Government should stay on the reform path to ensure the EU interest in Ukrainian gas transportation system, the modernization of which requires substantial investments.

Oleksandra Betliy
The Institute for Economic Research and Policy Consulting - Kyiv