Both candidates in the Feb. 7 runoff election for president of Ukraine proclaim reform in order to tap into voters’ deep dissatisfaction with dysfunctional politics and their leaders’ failure to cope with concerns of citizens in an economic crisis. Neither has much credibility, given that both twice served as prime minister and are perceived to have been as much part of the problem as the solution. Whoever is elected will have a small window of time to use the electoral mandate to recover from the sadly squandered opportunity of the 2004 Orange Revolution by setting a bold new path for reform.
Nowhere is this more evident and urgently needed than in the energy sector, which has suffered two decades of decay, inefficiency and massive corruption. This area also concerns Ukraine’s international partners, whose own interests are at stake and who can help if there is political will from Kyiv to embark on reform. Consequently, what the next Ukrainian president does on energy in his or her first 100 days in office will be watched carefully at home and abroad as the key indicator on whether it will again be business-as-usual or whether Ukraine will at last get a leader to enact changes its society demands.
For energy, the first order of business is to stabilize the critical gas relations with Russia, which have been plagued by many years of non-transparency and designed instability. When Central Asian gas was cheap and West European gas prices dear, billions of dollars per year were siphoned off in corrupt schemes by the politically privileged at the expense of ordinary citizens in producing and transit countries. The market conditions of the 1990s transition period are gone forever. The Jan. 19, 2009, gas supply and transit agreements go some ways toward modernizing the gas relationship between Russia and Ukraine. However, they are inadequate, as evidenced by constant adjustments of critical terms, such as volume obligations and transit tariff, in the first year of what were supposedly 10-year agreements.
Any agreement that requires frequent political discussion by prime ministers and commercial renegotiation by heads of Gazprom and Naftogaz is inherently unstable. The objective for Ukraine should not be the lowest possible price for imported gas or the highest possible price for gas transit as some suggest. Three-quarters of the gas from the direction of Russia to West European markets are shipped through Ukrainian pipelines. The fragile Russian-Ukrainian gas relationship is steadily eroding this important asset, inherited from geography and Soviet legacy. Expensive new pipeline projects such as South Stream and Nabucco are proposed for the principal purpose of replacing Ukraine as the vital transit corridor for gas to Europe.
With a couple of billion dollars, Ukraine can renovate and expand its pipeline capacity to carry the volume of gas to be transported by new pipelines, which will cost tens of billions of dollars each. As long as it is recognized as an unreliable transit country, gas producers and consumers will seek economically sub-optimal solutions in order to bypass Ukraine. Pipelines on the drawing board and imports of additional liquefied natural gas can replace in time all the transit capacity of Ukraine. Without updating its gas transit relationship with Russia as the principal if not only shipper, investment projects to upgrade Ukraine’s pipelines are simply not bankable, as should be clear by now despite the March 23, 2009, declaration by Ukraine and the European Union in Brussels.
Russia and Ukraine must first agree to reasonable gas transportation terms with financially-secure volume guarantees by both sides and a tariff mechanism that reflects operational cost recovery and maintenance, as well as economically justified reinvestment, for a period of 20 years or longer. Then Ukrainian pipeline revenue can be protected and increased through volume growth, not just tariff increases.
Internationally standard long-term contracts take many months to negotiate properly and cannot be concluded in a couple of evenings or weeks as had been the Russian and Ukrainian custom, only to be followed by frequent renegotiations. The new Ukrainian president should chart a course for mutually beneficial gas relations with Russia, starting with extracting Ukrtransgaz [the gas transit daughter company] out of the black hole that is Naftogaz and compelling it to operate in a transparent and credible manner. Without this essential condition, no external funding of investments in the gas transit and storage system will be forthcoming.
Restructuring Naftogaz itself will be a much more difficult and laborious task. One of the principal, but by no means only, reasons why Naftogaz is a bankrupt (un)natural state monopoly is multi-tiered domestic gas pricing. Naftogaz is forced to sell to different classes of consumers at prices lower than what it pays for imports. At the same time, domestic gas producers are disadvantaged by having to sell at an artificially low price which is a small fraction of the imported price. In effect, expensive imports are subsidized by cheap domestic supply, leading to highly-corrupt grey market operations. Small wonder unqualified financial statements and audit reports in this majority state-owned sector are difficult to find.
As a consequence, legitimate domestic and foreign investors are discouraged from fully developing Ukraine’s ample oil and gas endowment while revenue and asset stripping of state assets are prevalent. The average consumer endures poor and undependable service even though low energy prices are justified in his name. State assistance and subsidy should target the truly needy in society. Low overall prices instead lead to wasteful consumption by those with special access to cheap gas, while the rest of the population suffers spot shortages. Ukrainian industry has the highest energy intensity in the world. Energy efficiency will not improve substantially without prices being freed to market-clearing levels.
Advocating real energy reform requires political courage anywhere in the world. In this moment of crisis, the new Ukraine president will have a unique opportunity to invest political capital gained from a national mandate to lead desperately needed energy reform. Without it, Ukraine’s energy economy will be in even more dire straits in five years’ time. By then, international financial institutions, the European Union and United States may no longer be so interested to offer financial and technical assistance as they are today. The world will have moved on, with or without Ukraine.
Mr. or Madam President-elect, in spite of their past disenchantment, your own citizens and your international partners anxiously await your next move on the energy front.
Edward C. Chow is a senior fellow at the energy and national security program of the Center for Strategic and International Studies in Washington. He has been an occasional adviser to various Ukrainian governments over the past 10 years.
