President Petro Poroshenko, in promising to clean up Ukraine's corrupt energy sector in his annual speech to parliament, said "opaque gas fumes will no longer light up Forbes global rich list with Ukrainian names."
Ukraine’s energy sector has been plagued by an alliance of Russia, local oligarchs and a popular belief that home heating should be free.
One of Ukraine biggest lenders, the International Monetary Fund, estimates that energy subsidies cost the global economy more than $500 billion per year.
This gigantic figure shows that energy flows are highly vulnerable to capture by corrupt business groups and their political allies, who claim democracy can be traded for protection from modern economic realities.
Until as recently as the turn of the millennium, oil prices were comfortably below $30 per barrel (gas prices are linked to oil prices). Not only was energy cheap, Ukraine was a major oil and gas producer. While the pipelines running through Ukraine are now famous for bringing Siberian gas to Europe, much of this infrastructure was built to bring western Ukrainian gas to Russia.
Ukrainian natural gas production peaked in 1975 at 68.1 billion cubic meters (bcm), 37 percent more than the country’s entire consumption last year.
From the 1970s onwards, the Soviet Union shifted its energy extraction to large Siberian fields being discovered and unlocked by new technologies.
Gas production in Ukraine was left to wither to last year’s level of 13.7 bcm, down 80 percent on the 1975 figure, but massive extraction elsewhere in the Soviet Union more than made up the shortfall. In this environment of cheap global prices and plentiful regional production, millions of Ukrainians grew up believing that gas was essentially free.
After Ukrainian independence in 1991, several factors combined to turn the natural gas market into one of the country’s biggest weaknesses.
The fact that Ukraine had allowed its energy production to be outsourced to Russia created a political dependency that only now is beginning to be broken through “reverse flows” of gas from the European Union, which have surpassed 60 percent of total imports at times this year.
Billions of dollars of transactions at Ukraine’s borders created rich pickings for oligarchs ranging from former Prime Minister Yulia Tymoshenko to Dmytro Firtash. As the more gas was wasted in Ukraine, the more gas would need to be imported from Russia this led to energy inefficiency on the level of Ukrainians opening apartment windows in spring and autumn to let heat out.
Eventually, someone had to pay the bill for the deals and side deals between the Kremlin and their Ukrainian partners. The suspicion, of course, is that the tradeoff of such sweet deals was subservience to Moscow.
The cost of these schemes can be seen in Ukraine’s appalling roads, schools and hospitals, which have been starved of investment as the government continued to give essentially free gas to households, even though the global oil price quadrupled between Ukrainian independence and the EuroMaidan Revolution last year.
The cost came in other ways as well: $500 million to $1 billion in monthly subsidies from taxpayers to state-owned Naftogaz, which have now been signficantly reduced.
The energy company’s new 36-year-old CEO Andriy Kobolyev described the old gas market model as one where the population was bribed with cheap gas in exchange for not questioning how the industry was generating billions of dollars for a tiny elite.
Whether corruption has been stamped out from Ukraine’s energy sector is a hotly debated topic.
Dragon Capital energy analyst Dennis Sakva told the Kyiv Post: “Proving the absence of something is famously scientifically impossible. Seeing 1,000 white swans doesn’t prove that black swans don’t exist. The former leaders of Ukraine’s energy sector were quite openly corrupt, for example, signing procurement contracts with their friends for twice or three times the market price. This has changed and there are several other examples of noticeable improvements in the gas sector especially in Naftogaz corporate governance standards.”
Citing past corruption at Naftogaz, its current CEO Kobolyev told Ukrainska Pravda that the company’s former leaders didn’t become wealthy by some minor schemes such as, “buying office pens for Hr 100,” they enriched themselves through well-known schemes such as using intermediaries to buy gas from Russia and selling gas to allies at preferential rates.
On three occasions, the voraciousness of Ukraine’s gas sector extended beyond the capacity of state finances and the IMF had to be called in.
In 2008, the government of former gas trading mogul Yulia Tymoshenko promised to introduce market prices in the course of three years. Instead prices fell further in dollar terms.
Again in 2010, the Ukrainian government, this time led by Mykola Azarov, promised market prices within 2.5 years. Again this promise was entirely ignored the moment IMF funding was unlocked.
Ukraine’s new IMF program penned this year appears to be different.
Firstly, there seems to be a case of the IMF having wised up and become serious about holding Ukraine’s government to its word.
Secondly, Ukraine is now unable and unwilling to auction off its sovereignty to Russia in exchange for cheap gas and continuation of corrupt schemes.
Naftogaz spokesperson Aliona Osmolovska told the Kyiv Post that charging market prices for gas will lead to many positive outcomes such as stamping out corruption, improving efficiency, and boosting local production and thus lowering imports.
While the volatility of Ukraine’s currency over the past year and the outgoing system of Byzantine price categories makes economic analysis difficult, it is safe to say that gas prices for households in dollar terms have tripled despite the currency having fallen nearly threefold.
The government promises subsidies for those who cannot afford to pay, but with most of the Ukrainian population living uncomfortably close to the global poverty line, more economic pain is ahead.
The economic crisis, alongside public impatience with slow reforms and an inffective battle against corruption, have led to a drop in popular support for Prime Minister Arseniy Yatsenyuk and, to a lesser extent, President Petro Poroshenko.
But if Poroshenko and Yatsenyuk end up helping to spur changes that reduce corruption in Ukraine’s energy sector and put the nation on a path to energy independence despite the other severe challenges the country faces, they – like the Ukrainian consumers who will pay market rates for gas – may find the price is worth it.
