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You're reading: Ukraine’s energy security hostage to domestic pricing, not Russia
You may have noticed that Ukrainian government officials, as well as the country’s opposition politicians, never seem to tire of commenting on the status of the ongoing “natural gas price negotiations” between Ukraine and Russia.

One politician says that the pricing formula is unfair, a second that the transit volumes through the Ukrainian pipeline should be guaranteed, a third that the pipeline should be managed by a three-way European Union-Ukrainian-Russian consortium, a fourth that a giant new terminal should be built on the Black Sea for diversification purposes. And so on and so on.

Ukraine’s various political camps have been blaming each other for the high Russian gas price for as long as anyone can remember.

Conveniently, in the course of such recriminations, Ukraine’s 20-year, decidedly non-partisan corruption and mismanagement of its own domestic energy sector rarely surfaces for discussion.

The global media has its own fetish for the Ukrainian-Russian gas topic. After the famous 2006 and 2009 “gas wars” that cut Russian gas supplies to Europe in mid-winter, it’s always an easy story for Reuters, AP or Euronews to pull out of the file to get the man on the street’s attention for a couple of minutes.

The latest outbreak of frigid winter weather renews fears in Europe of another “gas war,” making for some dependable theater on a slow news day

Russia’s leaders clearly do not mind the media circus surrounding the gas situation, as it tends to aid their ongoing public relations campaign to cast the Ukrainian state as an unreliable and unstable player on the international stage.

The Ukrainian-Russian “gas question,” has turned into a massive smokescreen which usefully serves the purposes of all sides, even though none of the basic issues ever really change or are fundamentally resolved by the negotiations.

The mundane truth is that Ukraine’s energy woes are only marginally related to the celebrated Russian gas price. Media reports generally do not mention that Ukraine is itself a major producer of natural gas, with more than 1 trillion cubic meters of proven reserves, and that it is the inefficient use of this vast domestic resource that is the real root of the trouble.

The most valuable Ukrainian company you’ve never heard of – the generically-named, state-owned UkrGazVydobuvannya (UkrGasProduction) – is the de facto custodian of most of these reserves, and it extracts an impressive 15 billion cubic meters of natural gas per year, worth around $5.5 billion at today’s average European price.

In theory, this gas is used to provide heating to domestic households at a heavily subsidized rate of about $90 per 1,000 cubic meters, or more than four times lower than the current Russian import price of $415 per 1,000 cubic meters. In practice, no one but shadow energy industry bosses and a cadre of well-placed, government-appointed managers at Naftogaz (the state energy monopoly which controls UkrGazVydobuvannya) knows exactly where all of this domestically-produced gas ends up.

Although anyone attempting to uncover the precise details would likely find himself in extremely unpleasant circumstances, it is an open secret that, under every Ukrainian government of the past 20 years, a portion of the domestic gas output has been obtained by insiders at the household rate.

The gas is then “laundered” through gray-market intermediaries and exported at European prices or re-sold to industrial consumers in Ukraine at a gigantic markup.
Ukraine’s various political camps have been blaming each other for the high Russian gas price for as long as anyone can remember.

The multi-tiered pricing structure openly invites graft, with some of the richest Ukrainians as the end-beneficiaries, while the entire scheme hides under the politically unassailable pretense of keeping babushkas’ utility bills low. It’s like taking candy from a baby.

President Viktor Yanukovych came to power promising to implement wide-ranging economic reforms which would, among other things, reduce corruption in the energy sector.

Although the President struck a serious tone with his rhetoric, two years have passed, and nothing concrete has been achieved in this area.

The current government, just like the previous one led by Yulia Tymoshenko, has been telling the International Monetary Fund that losses from “household” gas subsidies can simply be offset by budget cuts in other areas, or by a lower Russian import price. The IMF has yet to be swayed by this dubious argument, and Ukraine’s $15 billion standby loan program remains locked down.

The often-heard thesis that Yanukovych and the ruling Party of Regions cannot raise the household gas price in an election year due to political costs carries certain legitimacy. Ukraine will hold a parliamentary election in late 2012, and all the main opposition parties are taking a hard-line populist stance against utility tariff rises.

However, this view fails to explain why the domestic energy sector was not liberalized in the preceding two years, a period free of national elections, and begs the question of what the next excuse for inaction will be when 2013 and 2014 roll around.

Yanukovych had no particular difficulty in pushing through an unpopular pension reform last year which raised the retirement age, nor in enacting the Tax Code in late 2010, which forced many small businesses that had previously operated in the shadow economy to begin paying taxes. Both of these steps, it should be noted, brought Ukraine closer to the norms of the civilized world and required a considerable amount of political courage.

However, the crucial difference between raising the retirement age and raising domestic gas prices is that in the former case, there is no entrenched, powerful lobby earning billions of dollars per year from the status quo to resist the change. The people affected by pension reform are not fat-cat oligarchs with a direct line to the head of the presidential administration, but destitute retirees or small business owners who can only protest by waving placards in the street or with their vote.

Deputy Prime Minister Sergiy Tigipko, the principal architect of the Tax Code and pension reform, has recently been on television proclaiming that instead of raising domestic gas and heating tariffs, the Ukrainian government intends to concentrate on “increasing energy efficiency.”

The irony here is that as one of the most successful private entrepreneurs in Ukrainian history, Tigipko surely knows that free market pricing will do an infinitely better job of “increasing energy efficiency” than even a government with the purest intentions, let alone one with Ukraine’s dismal historical track record.

Tigipko’s hands may be tied by the official pro-presidential line against utility tariff hikes, but he is fully aware that what needs to be done in Ukraine is the same as what was done in Poland, Slovakia and the Baltic states in the 1990s: artificially low domestic energy prices must be phased out for the health of the overall public sector economy.

Leaving energy efficiency improvements solely in the hands of Ukraine’s government while maintaining distorted pricing is akin to letting the fox guard the henhouse.

The potential good news is that as soon as Ukraine brings its domestic tariffs into line with economically reasonable levels, the gas conflicts with Russia will lose their political character and become a purely business issue, similar to Gazprom’s relations with its customers in the EU.

Liberalized prices combined with a structural reorganization (and likely partial privatization) of the domestic gas industry’s crown jewel, UkrGazVydobuvannya, should result in a sharp rise in Ukrainian gas extraction, perhaps to as much as 30 billion cubic meters annually within a few years.

If Europe were to see that Ukraine is finally serious about energy reform, the EU’s interest in participating in a modernization of the Ukrainian pipeline system would likely perk up considerably. The country could even become a net exporter of natural gas down the road, with the infrastructure already in place to pump fuel westward.

Ukraine is in the enviable position of being well-enough endowed with natural resources to control its own energy destiny in the coming decades.

Despite the never-ending hoopla and speculation over what price Russia will or won’t offer Ukraine for gas imports, the solution to the gas issue lies not in Moscow, nor in Washington, Brussels or Berlin, but right here in Kyiv.

Will Ritter is a Kyiv-based freelance writer who can be reached at

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