Household electricity tariffs in Ukraine are a prime example of good intentions gone bad. To ensure that poor households have access to adequate supplies of energy, household tariffs for electricity (and for gas), have been set at extraordinarily low levels – well below the levelized cost of electricity – the average cost of electricity generation for a generating plant over its lifetime – regardless of whether the source of the electric power is nuclear, thermal, solar, wind, hydro or combined heat and power.
It also is well below the household electricity prices set in the European Union; in December 2020, the German household electricity price was $0.37 per kWh, France was at $0.22 and Poland at $0.19. As noted earlier, Ukraine’s official household price (including VAT and tariffs) is Hr 1.68 or $0.06. Moreover, it will even be reduced starting Oct. 1 for households consuming less than 250 kWh per month to Hr 1.44 or $0.05.
The first-best way of achieving the social objective of ensuring adequate supplies of energy to all households is to ensure that every electricity user (household and business) pays the long-run social marginal cost of generating and distributing electricity and to use the central government’s fiscal transfer mechanism to deal with any undesirable social consequences. This requires the government to know who the poor citizens are and to have the fiscal and logistic means to supplement their inadequate incomes. Ukraine would be well-advised to invest in enhancing its redistributive fiscal capacity. This would require a meaningful broadening of the tax base through a determined assault on the size of the informal sector, which is largely outside the formal tax net.
The first-best fiscal solution was rejected by all past and present Ukrainian governments. Instead, they have opted to keep household electricity tariffs low across the board – well below long-run social marginal cost. Even if the state were to compensate the suppliers of electricity for the resulting revenue shortfall, this would encourage wasteful overconsumption of energy by households, damaging Ukraine’s prospects for meeting its commitments to enhance energy efficiency and curb greenhouse gas emissions under the Paris Club Accord.
Ukraine inherited the low electricity tariffs for households from Soviet times. In order to keep them at the required level, a cross-subsidization mechanism is used: household tariffs are subsidized either by higher tariffs for industrial users of electricity or by lower profits (and possibly losses) for the sellers of electricity. In mid-2020, the new electricity market model was launched in Ukraine replacing the outdated “single-buyer model”. According to the law, the cross-subsidization should have been eliminated before the launch of the new market, but it still exists and continues to create obstacles for the normal development of both energy and the economy as a whole. The problem is compounded by the fact that industrial tariffs are also among the lowest in Europe.
The electricity market is financially imbalanced. Even the renewable energy sector, which attracted investment through the prospect of quite generous feed-in tariffs – is now underperforming, despite a partial bailout by the Ukrainian treasury. The electricity system has been starved of financial resources for years, and the results are not surprising but extremely worrying. When profits are inadequate, capital expenditure on infrastructure, facilities, plant, equipment, and innovation suffers. When profits are sufficiently poor, even basic operational expenditures suffer.
The result will be an increasing frequency and severity of power outages across the country. Even worse, the state-owned nuclear power generator, Energoatom, has not invested adequately in operations and maintenance for years and now falls short of what is required to maintain essential nuclear safety.
The shambles that is Ukraine’s energy sector is simply in no condition to undertake the energy transition to the climate-change resilient partnership with the European Union that will ensure that Ukraine stays on the right side of the EU’s enhanced climate policies, including notably the carbon border adjustment mechanism (CBAM).
The good news is that the policy and regulatory changes that are required to bring Ukraine’s energy sector into the 21st century are plain for all to see. What is required is radical reform. This includes a full settlement (using public funds) of all outstanding debts and the resumption of energy market liberalization, including the privatization or much more effective regulation of state-owned enterprises, notably Energoatom and Ukrhydroenergy.
A break-up of Energoatom, accompanied by privatization or much more effective regulation, is long overdue.
Other monopolies (including some involving distribution system operators) can be addressed by regulatory measures and/or by encouraging entry, including foreign entry -most likely from the EU. Entry will only happen, though, if the business climate in the sector (and indeed in the economy as a whole) improves materially.
As important as the termination of abusive monopolies – including state monopolies – and the creation of a truly independent regulator is the creation of market conditions that allow competitive market participants to earn adequate profits.
Ideally, both households and industrial users of electricity will pay the full long-run social marginal cost of supplying the energy. If subsidization of household tariffs remains a political necessity, the full cost of the subsidy should be borne by the national treasury. The end of cross-subsidization is a necessary condition for creating a business and investment climate that will allow Ukraine to, at last, realize its potential for development, growth, and prosperity.
Willem Buiter is a visiting professor at Columbia University and a member of the DTEK Advisory Council.
