For many years, the pricing of natural gas in Ukraine has been at the center of corruption, inefficiency, fiscal mismanagement, the balance of payment problems, and Russian manipulation.
After many years of reformer pressure, Ukraine finally adopted a policy of market pricing which has resulted in a substantial reduction in corruption from dual pricing, has vastly reduced the volume of gas consumed, has contributed to a dramatic reduction in the fiscal deficit, has resulted in a major improvement in the balance of payment and has dramatically reduced Russia’s influence on Ukraine. All of these potential benefits were well understood by economists and the international institutions providing advice. Thus, the International Monetary Fund, and other lenders, made the market pricing of gas a condition of financial support.
Unfortunately, despite all the above benefits and with little reason beyond political populism, the policy of market pricing of gas has recently been reversed. The Ukrainian government announced a price cap on the cost of natural gas to household consumers of 6.99 hryvnia per cubic meter.
This represents approximately a 30% cut to the prevailing domestic market price of 10 hryvnias per cubic meter and will effectively again create a dual pricing regime differentiated by household and commercial/industrial users. It will, most immediately, have the effect of violating the terms of agreement for further tranches of IMF funding and potentially losing support from other international institutions. While proposed as a temporary measure, it is well known that once price controls are introduced, their removal becomes very difficult politically.
The justifications advanced for the policy reversal should be scrutinized for validity.
First of all, it has been proposed that the price cap was necessary to protect the consumer who has been further weakened as a result of the prevailing COVID-19 pandemic. While it is undeniable that financially vulnerable consumers need support, such support is much better provided by extending targeted financial subsidies rather than lowering gas prices to all. This approach was originally adopted and served to reduce both the demand for natural gas as well as the cost of subsidization. By mandating Naftogaz to provide households with gas at a reduced price, the government is effectively reducing the revenue which would ultimately accrue to the state as owner.
Another justification proposed for the reversal is that the market is not fully competitive and that intermediaries are engaged in gouging the household consumer. While this argument may have some validity, the appropriate remedy is to have the competition tribunal review the degree of monopolization and the margins being earned. However, based on the pricing of natural gas in the nearby EU markets, the arbitrarily set pricing of 6.99 hryvnia appears to substantially understate the full cost of natural gas to households which would pertain to a fully competitive market. At the present time, the trading price of gas at the Central European Gas Hub in Austria is $6.8 per one million British Thermal Units or 6.97 hryvnia per cubic meter. As Ukraine imports gas from Europe, the marginal cost of gas to households should consist of the hub pricing in Eastern Europe, plus transmission, infrastructure, and other servicing costs. Clearly, the price cap does not represent a market price that must be substantially higher. Thus, intermediaries could not supply the household consumer with gas at the controlled price.
Of course, domestic producers of natural gas may have production costs that are below the gas hub price and may be forced to sell their production into the household market if the more lucrative commercial/industrial markets are saturated. The result of the price cap would then be to reduce the revenue available to the private producers of Ukraine. This may violate the expectations of such producers that an open market would be available for their production and may, subsequently, result in a reduction of investment in new gas wells. In the longer term, Ukraine’s ability to attract either foreign or domestic investment into the sector will be jeopardized. In fact, with Naftogaz required to sell at below-market prices, the available cash flow for reinvestment will clearly be reduced. While Ukraine has the potential for gas self-sufficiency, a reduction in investments will result in failure to meet such goals.
Finally, the argument has been proffered that if Gazprom were forced to act competitively rather than as a monopolistic supplier, the price of gas in Ukraine would be at a lower level. The monopolistic behavior of Gazprom which prevents the transfer of gas ownership at the Ukraine-Russia border is well-known and is a factor that the European Union competition bureau has long ignored. Ukraine should continue to make every effort to have such monopolistic practice declared unlawful. In such an event, the gas supplies to Ukraine could come from a “virtual” reversal also known as gas swaps which would make market prices in Ukraine lower than EU hub pricing due to a reduction in transmission costs. Unfortunately, these are not the conditions that currently prevail and thus do not have any economic grounding.
In conclusion, the announced reversal of market pricing policies for the household consumer constitutes a very poor economic policy. It offers a cosmetic value that may well appeal to the voting public but, in fact, is simply an exercise in populism that will result in damage to the gas industry, the government’s fiscal balance, and the general economy.
