From the incident in the Kerch Strait to the establishment of an independent Ukrainian Orthodox Church, recent events demonstrate that Ukraine’s struggle for independence is more than just mortar and artillery fire in the Donbas. Nowhere is that truer than in the energy sector.
When President Petro Poroshenko to power after the EuroMaidan Revolution prompted his predecessor, Victor Yanukovych, to flee power, energy reform became a central issue—partly because of International Monetary Fund conditionality, but also because of the enduring harm that energy-sector corruption and mismanagement have caused to Ukraine: pernicious budget deficits, energy insecurity, and sluggish economic growth.
But today, it seems progress on energy reforms risks backsliding. For example, in April 2016, the Ukrainian government moved to unify the price of natural gas for industrial consumers and households, which enjoy significant subsidies that have cost the government more than military expenditures.
Cutting subsidies has helped Ukraine remedy some of its economic woes, but there is populist pressure to increase subsidies and return to the old system. While import prices have increased over the last two years, household prices have stayed the same because the government’s hesitancy to raise utility bills. Part of the problem is that, despite recent promises to the contrary, there is no policy in place to prevent the government from fully reintroducing subsidies. Former Prime Minister Yulia Tymoshenko, who currently leads polls for the upcoming March 2019 election, already declared she would reinstate subsidies as a centerpiece of her presidential campaign.
Although energy subsidies prove to be politically popular, economists widely regard them as a poor form of social assistance because the wealthiest receive the most benefit from them.
Costly gas subsidies are a national security vulnerability for Ukraine, needlessly driving up deficits or crowding out other budgetary priorities like national defense. Because subsidies force the government to foot the bill for imports, out-of-control subsidy spending has left Ukraine at Russia’s mercy in the past. In 1993, Ukraine had to cede part of its Black Sea Fleet to Russia in exchange for energy debt relief.
It may seem that Ukraine is now less vulnerable to Moscow’s “energy diplomacy” tactics, but that is not the case. While Ukraine has not directly imported gas from Russia since November 2015, it has not yet fully disentangled itself from the Kremlin’s use of gas as a geopolitical weapon.
In a paper recently published by the Council on Foreign Relations, we outline the myriad ways that the Kremlin still interferes with Ukraine’s energy security. For example, Ukraine still imports Russian gas albeit through reverse flows from Hungary, Poland, and Slovakia. Russia is actively developing alternative pipeline routes like Nord Stream 2 that bypass Ukraine, making it more difficult and more expensive for Ukraine’s EU partners to re-export gas back to Ukraine.
More broadly, non-Russian sources of gas production in Europe are also tightening. More alarming, we found that Ukraine’s newfound independence from Russian gas could prove more tentative than permanent without the right policy changes. Although Ukraine’s gas consumption has been decreasing since independence, the more recent, drastic drops are directly attributable to conflict with Russia. The ongoing Russian occupation in Ukraine’s east and the annexation of Crimea alone account for more than half of the total decline in gas consumption between 2013 and 2015.
Ukraine’s gas consumption is projected to stay flat through the 2020s, but that could change if the conflict ebbs, economic growth picks up, or energy efficiency efforts do not significantly advance. Ukraine faces a no-win situation without advancing energy reform: It cannot resolve its conflict or realize its economy’s full potential without increasing its exposure to foreign gas supplies.
The good news is that Ukraine is in a position to produce its own economically viable gas. Ukraine’s gas production is remarkably low considering it holds the third largest gas reserves in Europe. Only 2 percent of Ukraine’s reserves are extracted annually, relative to an average of 6 percent for other gas producers. The barriers to increasing production are neither economical nor technical: According to both Naftogaz and external experts, the production cost of most Ukrainian gas is lower than what Ukraine pays for European imports and what it previously paid for Russian supplies.
To remedy the situation, Ukrainian policymakers should focus on the “above-the-ground” policy issues that prevent Ukraine, a country at war with Russia, from achieving energy independence.
In the paper, we recommend that Ukraine increase its energy security by depoliticizing gas prices, firmly establishing regulatory independence, and carefully dismantling energy-sector monopolies.
Most importantly, Ukraine will have to cede the authority to price natural gas to the National Energy and Utilities Regulatory Commission of Ukraine, or NEURC, its independent regulator. It is well-documented that countries that attempt fossil fuel subsidy reform without ceding pricing authority reverse course under political pressure—from Namibia, compelled by its powerful constituency of taxi drivers, to France, amid the “yellow vests” protest, today.
There are other important measures that Ukraine can take to advance energy reform. For example, the national energy regulator was ostensibly redesigned to align with EU energy legislation; in reality, Ukraine has yet to establish a body to effectively and independently enforce market rules that encourage energy-sector competition. Ukraine can strengthen NEURC by ensuring the commission is funded by user fees, eliminating direct presidential appointments of commissioners, and taking input from civil society and—for a limited time—the international donor community in selecting commissioners.
Another problem is that Naftogaz produces 75 percent of Ukraine’s gas, crowding out private investment that could turn Ukraine into net gas exporter in the next decade. Private companies that do attempt to produce gas in Ukraine also face a byzantine licensing system that impedes new participants and strengthens existing players. Simplifying licensing would go a long way to helping firms without an inside track enter the market, raising Ukraine’s energy production. Cautious, transparent privatization of Naftogaz’s production assets would also open more space for independent producers.
Jumpstarting Ukraine’s stalled energy reforms is a prerequisite for its economic success and overall national security. With the right policies in hand, Ukraine can put its energy reforms back on track before the next anniversary of the Euromaidan Revolution.
Sagatom Saha is an energy policy analyst and former visiting fellow at DiXi Group, a Ukraine-based think tank focused on energy-sector analysis. Previously, he was the research associate for energy and U.S. foreign policy at the Council on Foreign Relations and a Fulbright researcher in Ukraine.
Ilya Zaslavskiy is the head of research at the Free Russia Foundation, he also runs underminers.info, a research project devoted to post-Soviet kleptocracy in the West. He was previously a Bosch fellow at Chatham House and also serves as a consultant for energy projects in Eurasia after having worked in the oil and gas sectors of Russia and Ukraine for seven years.
