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Balancing between Debts and Regulations: Ukraine’s Gas Market in Winter

Andrian Prokip

BY ANDRIAN PROKIP

Traditionally, winter is a time of energy troubles for the Ukrainian government. The coming winter seems poised to present an even bigger challenge than normal owing to the energy price rally in Europe. To cope with the challenge, the government is considering applying a policy of “manual regulation.” The question is, will it be effective? And will there be unintended consequences?

State-Owned Companies Take on the Burden of Subsidization
The winter of 2021–22 is shaping up to be a difficult one for Ukraine. Gas prices in Europe are hitting record levels; Ukraine’s power stations have stored only about a quarter of the coal needed for the season; and most state-owned energy companies are unprofitable. In a low-income country like Ukraine, moreover, the energy prices paid by households are an especially sensitive matter, both politically and economically. To address this hot button issue, Ukraine’s cabinet and the state-owned company Naftogaz have committed to supplying gas to households, heating utilities, and state-funded organizations at fixed prices.

With the open market price spiking, however, the fixed price for households is on average four to five times lower than the market price. Thus Naftogaz faces two problems. First, it lacks its own gas production facility to meet the demand of Ukrainian consumers. In recent years Naftogaz has failed to meet government goals for gas production; on the contrary, it has decreased production. Only private companies have been increasing production. Thus the second problem: Naftogaz will have to buy, either from domestic producers or from abroad, gas from private companies at the very high market price, something the company does not have money for. In 2020 Naftogaz reported $685 million in losses, and it has not earned to cover shortfalls this year.

To solve this financial shortfall, the cabinet approved a $1.8 billion payment to Naftogaz from another state-owned company, the gas transmission system operator (GTSO), responsible for gas transmission and transit. The payment is considered to be a kind of compensation to Naftogaz for losing its gas transit fees after the unbundling stipulated in the European Third Energy Package in late 2019.

Debts between Natural Gas Monopolies: Squaring the Circle
The GTSO has tried to collect more money owed it, including from distribution system operators (DSOs). For years the DSOs did not pay their full liability to the GTSO, including some disputable debt arising from governmental misregulation of the industry. But the key reason was that the tariff introduced for gas distribution operations after the 2015 gas market reforms did not cover all the expenses companies incurred. This led to unprofitability of the DSOs and the subsequent underpayments to the GTSO. And the proximate cause for this foreseeable situation was something now traditional for Ukraine: the state tried to keep the tariffs low so as to provide lower prices for end consumers.

Another problem that contributed to the increased indebtedness of the DSOs arose last winter, shortly after the gas market was liberalized for households, which then had to pay a market price, but no longer a low regulated price. Some households reported lower levels of consumption in winter, hoping to pay for these volumes in summer, when the expected price would be lower. But that introduced revenue shortfalls that the DSOs, which were financially responsible for imbalances in the pipeline accounts—gas consumed but not paid for—could not cover, and the DSOs’ debts to the GTSO rose. Later, the government solved the problem of households shifting payments by introducing an annual price for gas for households.

Recently the GTSO pegged the DSOs’ debts at $332 million. However, a key question is what gas price was used to calculate that amount. Today the tariff for distribution prescribes that the gas price necessary to cover production and technological losses in the system is about $220 per thousand cubic meters. Because of rising market gas prices over the past year, the DSOs are not able to buy enough gas to cover the imbalance in accounts, and so are incurring new debts to the GTSO. Both the GTSO and the DSOs are captives of government regulations. They are not conducting business fraudulently, though that is how the situation is often portrayed politically in Ukraine.

The solution currently proposed by the government would obligate Naftogaz to supply gas to cover losses in GTSO and DSO pipelines at a regulated price. This mechanism would solve the debt problem and would prevent an increase in gas distribution fees, even during the current price spikes.

A Risky Approach for Ukraine’s Gas Producers
In light of the lack of funds to buy costly gas and insufficient production on the part of Naftogaz to cover the needs of households and utilities, officials began looking for more extreme solutions.

In mid-October Davyd Arakhamia, head of the parliamentary faction of the ruling party Servant of People, brought up the idea of capping prices for gas produced by private companies and selling the gas on to government-funded organizations at a regulated price. This step, a form of artificial gas price regulation that is strongly opposed by gas producers, should be only temporary, Arakhamia said, as a way to counter the gas price rally in Europe.

At first glance, this initiative might appear to be just an attempt to cope with the gas price crisis, which affects Ukraine as an import-dependent state. But it could turn out to be a short-sighted decision with harmful consequences for Ukraine’s gas producers and the country’s relations with international organizations such as the IMF, which want to see a robust gas market in Ukraine. It could also imperil Ukraine’s national security.

Chiefly, artificial regulation of gas prices threatens to open a Pandora’s box of unwanted consequences should the government give in to the temptation to reduce prices manually whenever it wants. Such a development is within the realm of possibility if one considers the long tradition of populism in post-Soviet Ukraine regarding energy prices and the many promises made by President Volodymyr Zelensky, leader of the Servant of the People Party, to decrease household energy bills during his election campaign. And in fact, the electricity tariff for some households was reduced in August 2021, even though the new price did not cover the cost of production and the key companies responsible for supplying power to households were unprofitable.

A second and related consequence is the blow to doing business predictably in an environment of unpredictable manual regulation, which in turn means a decline in investors’ interest in Ukraine. Last year the country experienced one of the lowest levels of foreign direct investment. True, to a large extent that was caused by the COVID-19 pandemic, but another contributing factor was the huge underpayments or nonpayments of the feed-in tariff to renewable energy producers despite legal guarantees that they would be paid. Manual regulation may completely kill off investors’ interest in gas-producing companies.

Finally, Ukraine must urgently boost domestic gas production to become self-sufficient. The current gas transit agreement with Russia expires in 2024, and that country is already engaged in a new round of attempted blackmailing over gas. Should Ukraine transit no gas after 2024, importing gas from Europe may be technically complicated and more expensive. Now is the time to work on boosting gas production to achieve energy self-sufficiency, which is intimately connected to national security and the economic welfare of Ukraine’s citizenry.

The opinions expressed in this article are those solely of the authors and do not reflect the views of the Kennan Institute.

About the Author

Andrian Prokip

Andrian Prokip

Senior Associate, Ukraine;
Energy Expert, Ukrainian Institute for the Future
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Kennan Institute

The Kennan Institute is the premier U.S. center for advanced research on Russia and Eurasia and the oldest and largest regional program at the Woodrow Wilson International Center for Scholars. The Kennan Institute is committed to improving American understanding of Russia, Ukraine, and the region through research and exchange.  Read more