This tax currently stands at 55 percent for the natural gas extracted from the deposits up to five kilometers in depth and 20 percent for the natural gas extracted from deposits deeper than five kilometers.
On Dec. 28, the parliament caved in under pressure from Prime Minister Arseniy Yatsenyuk and passed both the tax reform legislation and the 2015 state budget bill.
The law on tax reform has experts and the industry participants expressly articulating that the tax burden is enormous in comparison to any other European country that is attracting investors into its oil and gas market. Consequences of this measure are expected to be disastrous not only for the private gas investors, but for the whole country that is struggling to ensure its energy independence from Russia.
Legislative blackmail
Initially, such excessive tax pressure on natural gas producers was introduced back in summer 2014. It was supposed to be a temporary government revenue enhancement measure so much needed when the state finances are drained by the military actions against pro-Russian rebels in the eastern regions of the country.
By adopting these tax rates on a permanent basis the authorities, in fact, backed out of their earlier promises given twice last year not to apply such high tax rates in 2015. First time one such promise was given in August 2014 by the prime minister, who said the tax was a temporary measure.
The second time – when the representatives of various parties in parliament signed the coalition agreement after the Oct. 26 elections, which suggested the gas production tax for independent private businesses should not exceed 30 percent.
Despite the strong lobbying efforts and a number of open letters submitted to the president, the prime minister and the parliament, the tax reform law No.1578 was passed as part of so-called “Parliament’s fight with the gas oligarchs” campaign rolled out under the pressure of the populists claiming that the gas producers generate incredible profits by extracting mineral resources that belong to the people of Ukraine and, therefore, must pay higher taxes.
It is worth noting that the tax reform legislation was adopted by the parliament under immense pressure from the government that kept referring to the war in the east — an effective, universal and arm-twisting argument. The bill received votes of 250 members of the parliament, although the parliamentary coalition includes close to 300.
Interestingly, the first attempt to adopt the tax reform bill failed (the number of votes was insufficient), and it was approved on the second try only.
Grave consequences
Probably only few parliament members understand that the bill not only contradicts the declared policy on the gas market liberalization, but threatens to destroy private gas production industry in Ukraine in the very near future.
During the last five months, the government did its best to scare away the foreign investors by waging a real war on private gas production business in Ukraine.
There were plenty of unwise decisions taken, including doubling the tax rates and driving the private companies out of the gas supply business by making Naftogaz, the largest state-owned company, the monopolist gas supplier to industrial and commercial consumers in breach of many laws and international treaties. These actions are far from resembling the “market opening” policy declared by the Yatsenyuk’s government on numerous forums. In the opinion of many international institutions, the government’s efforts should be directed in a quite opposite direction.
For example, in its September Country Report the International Monetary Fund mission expressly recommended to the Ukrainian government to abandon the policy of increasing subsoil charges as “the large increase in gas extraction royalties may delay investments in this strategically important sector of the economy, especially if expectations that it will be extended beyond 2014 take hold.”
The Energy Community Secretariat had previously requested clarification regarding the government’s decision to suspend open gas market by obliging around the largest industrial consumers to buy gas exclusively from the state-owned Naftogaz.
Apparently, the tax reform goes against the recommendations of the International Monetary Fund and the European Commission. The international institutions still expect the Ukrainian government to ensure non-discriminatory, transparent and stable environment for the foreign investments, especially in such a sensible sector as production of hydrocarbons.
No capital investment
The major issue is that these days when the Cabinet of Ministers should have been focusing on maximizing the country’s domestic gas production, the new tax reform actually dismantles the private sector of gas production industry in such energy thirsty country. By raising the royalty tax rates to the levels unprecedented in Europe, the government ruins the major incentive for the foreign investors – a relatively high netback.
As a matter of fact, no European gas importing countries have ever established such high taxation of domestic producers. Usually the rates in such countries rarely exceed 20 percent.
At the same time, according to various calculations, Ukraine will require some extra 37,000 cubic feet of natural gas of domestic origin already in 2015. But the growth of hydrocarbons production in Ukraine is conditional upon significant growth of capital investment, and according to some experts’ estimates, the country needs at least $1 billion annually during the following five years in order to achieve energy independence.
The increased fiscal pressure is already resulting in erosion of capital in this sector, unstable economic situation, while the threat of an open conflict with Russia and withdrawal of major international servicing companies will most likely discourage investors from directing additional capital in the gas production industry in Ukraine.
The tax burden in Ukraine is so high that the gas sector has already become non-attractive for foreign direct investment. For example, British public companies JKX Oil & Gas and Regal Petroleum have announced that they will not spend capital in 2015 to offset the impact of higher production taxes.
The second-largest U.S. energy producer Chevron Corp. took the decision to pull out from a production sharing agreement with the Cabinet of Ministers of Ukraine for exploring the Oleska field in western Ukraine. According to unofficial sources, Chevron grew frustrated exactly with the Ukrainian government’s failure to modify tax rules and red-tape under which foreign explorers have to operate in the country and its failure to reduce the “endemic corruption.”
Business to worsen
The tax reform will only worsen the level of corruption in Ukraine as the companies will not be able survive this unsustainable level of fiscal pressure on the industry. Transparency International has already stated in 2014 that Ukraine is “still remaining in the club of totally corrupt countries”.
High taxes have always been one of the main drivers of corruption, while reduction in the tax pressure is likely to lead to a reduction in the size of the shadow economy and corruption.
European countries are trying to create a virtuous circle by lowering taxes to minimize incentives for the business to go in shadow. At the same time, Ukraine creates a vicious circle in the other direction.
One possible outcome of the tax reform can be Ukraine’s continuous dependence on gas supplies form Russia and loss the prospects of reviving its chaotic economy. Already weighed down by the war, and teetering on the verge of default, Ukraine now may count only on foreign capital to develop its domestic gas resources.
The best way for the country to gain energy independence, bring down the level of corruption in the energy sector and comply with expectations of international donors is to create a favorable investment climate with acceptable stable tax regime.
Robert Bensh is an American energy and security expert and managing director and partner with Pelicourt LLC, a private equity firm focused on energy and natural resources in Ukraine.
