In the years since Ukraine regained its independence, the dysfunction of its energy sector laid at the heart of its underperforming economy. The long-delayed transition from command economy leaves Ukraine even today with energy-inefficient industries, poor energy services, and stagnant to declining domestic energy production. For most of the last 30 years, the energy sector has been the playground of politically connected groups for division of spoils rather than for creating economic value to profit society. These are facts well known to the Ukrainian public.
Now is the time
The still relatively new Ukrainian authorities have an unprecedented opportunity to reform the energy sector. For the first time since independence, there is a government that enjoys a simple majority in the Verkhovna Rada. Therefore, it does not have to bargain with other political parties by parceling control over economic segments, including in energy, to form a cabinet of ministers. This government has laudably ambitious goals to modernize Ukraine — 40% GDP growth over five years, $50 billion in foreign direct investment, privatization and market competition. The energy sector should be a mighty contributor rather than a drag on the economy.
In order to sustain reform, a democratic government must articulate the principles behind its policies and garner public support. This is especially true for Ukraine given past history and natural distrust by society. Governments are tempted sometimes to take credit for favorable developments not of their own making, such as lowering of consumer prices due to global oversupply of natural gas and warm winter. The same governments then expose themselves to blame when prices rise due to factors they cannot control. It is far better to concentrate on systemic reform, such as accelerating market liberalization at this politically opportune moment. Manual control got Ukraine into its current poor economic condition. Structural change is what President Volodymyr Zelensky and his party ran and won on last year with the overwhelming support of Ukrainian voters.
Competition needed
In a sector requiring investment projects with long lead times and payback periods, well-understood and stable government policies are key to attracting private capital, foreign and domestic. Reversing previously agreed, internationally supported policies, such as on renewable energy tariffs, imperil a favorable investment climate based on investor rights and rule of law.
It is better to promote competition, ensure transparent regulation, and negotiate mutually acceptable solutions with long-term investors as ways to achieve proper energy services at reasonable prices. By themselves, low prices will only return Ukraine to wasteful consumption, inadequate investment, and corrupt access to energy. As the European Union starts its Green Deal, Ukraine must advance toward an efficient low-carbon energy economy to gain access to export markets and integrate with Europe.
Perhaps the greatest potential wasted in the last 30 years is domestic gas production.
Stuck at 20 bcm yearly
Ukraine used to export gas to the rest of the Soviet Union, including Russia. Since independence, domestic production has been stuck at around 20 billion cubic meters per year, no matter whether the gas price is $50 or $250 per 1,000 cubic meters. The problem is not one of geology, but the way the market functions or rather is not allowed to function. A state company, UkrGasVydobuvannya, produces 70% of Ukraine’s gas. Another majority state-owned company, Ukrnafta, produces almost all of Ukraine’s domestic oil.
Conflicts ahead
Recently the new government kept the state oil and gas company Naftogaz and its major subsidiaries, such as UkrGasVydobuvannya and Ukrnafta, on a list of state assets not to be privatized. What does that tell us about how it plans to organize this sector in the future, even as it professes strong interest in attracting private investment? If the correct policy is to unbundle UkrTransGaz, the gas pipeline monopoly, from Naftogaz at the insistence of the European Union and other donors, what is the future role of UkrTransNafta, the oil pipeline monopoly? Is it these state companies’ job to compete, partner, or protect state interests with the private sector? They cannot perform all these functions simultaneously, at least not well, as they conflict with each other. Meanwhile, state enterprises will do what they do best: preserve themselves.
Stop ‘sleeping licenses’
Investors need to understand the organizing principles behind government policies on energy. Otherwise, projects involving large investments and long implementation will not proceed, as they compete for capital internationally. Luckily there are ample lessons learned and internationally accepted business practices from a century and half-old global industry. For example, exploration and production licenses should come with defined work programs and acreage has to be relinquished if conditions are not fulfilled within reasonable time. No “sleeping licenses,” as they are called in Ukraine, should be allowed, including or maybe especially for state companies. It is all well and good to have a transparent digital system to manage tenders, but what about preparation beforehand with equal access to geologic data, model contracts for easy comparison of bids, and elimination of prolonged negotiations of terms after awards are made?
Should the energy ministry and state geological service not conduct investment roadshows internationally in order to maximize competition and obtain the best economic value for the state? Ukraine’s reputation is of a market designed for insiders and open for unfair treatment.
The recently agreed five-year contract on gas transit with Russia’s Gazprom provides Ukraine with valuable time to build a resilient modern energy economy. With gas self-sufficiency and perhaps even net exports, Ukraine becomes an asset to Europe’s energy security rather than a liability. This advances Ukraine’s goal of integrating into the transatlantic community.
Don’t squander chance
However, reform of the pervasively corrupt and dysfunctional energy sector will not be easy. The first step is for the government to explain the economic principles and benefits of the reforms it proposes in order to gain public trust. With sound policy, friendly governments can assist with capacity building for policy implementation and investors will invest.
No less than land reform, energy reform is a sensitive issue that provides abundant potential rewards but also political risks absent public confidence.
A 30-year wait is long enough, it is time for the government to pronounce its vision for energy reform, engage the public and their elected representatives, and proceed.
Edward C. Chow is a senior associate of the energy security and climate change program of the Center for Strategic and International Studies in Washington DC.
