Ukraine’s natural gas industry won a landmark case against Russia on Feb. 28, when a Stockholm arbitration court ruled that Gazprom, Russia’s state-controlled gas company, owed its Ukrainian counterpart Naftogaz $4.6 billion for failing to deliver gas to Ukraine for transit onward to Europe.
After taking into account a previous ruling requiring Naftogaz to pay debts to Gazprom, it meant the Ukrainian state company was owed nearly $2.6 billion by Russia’s giant, state-controlled gas company.
It was a stunning victory for Kyiv. But experts say this is just one battle in a broader war to protect Ukraine’s energy security — and the country isn’t necessarily winning.
Russia and Germany have started constructing Nord Stream 2, a gas pipeline running under the Baltic Sea that would circumvent Ukraineю Meanwhile, the TurkStream pipeline from southern Russia to Turkey is near completion.
Both could deny Ukraine gas transit fees worth at least two percent of the country’s gross domestic product.
The front line in Kyiv’s struggle for energy security is reform of the sector. But politics is increasingly standing in the way.
And some doubt that Ukraine has the will to push through reforms and fight entrenched corrupt practices.
“I was struck—even when I was in Kyiv at the end of last year — by how much people were talking about elections,” says Edward Chow, an energy expert at the Center for Strategic and International Studies, or CSIS, think tank.
“And elections seem to be stalling the process.”
Gas transit corridor
Despite four years of war with Moscow, Ukraine remains deeply dependent on Russian energy: gas, crude oil, petrol, and coal.
The country also plays the role of a transit corridor for Russian gas sold to Europe.
In 2017, Ukraine transported around 93 billion cubic meters of Russian gas through its pipelines, only slightly more than the projected capacity of Russia’s current pipeline projects.
Moscow uses 80 percent of Ukraine’s gas transportation capacity, according to UkrTransGaz, Ukraine’s state gas transport system operator.
Since 1991, so-called “gas wars” have repeatedly flared up between Naftogaz and Gazprom over gas prices and outstanding debts, threatening gas supplies to both Ukraine and Europe.
At times, the conflicts have even led to temporary shut-offs. The case heard in Stockholm dealt with two agreements that Naftogaz and Gazprom reached in January 2009.
But the conflict over them erupted as part of the broader collapse of relations between Kyiv and Moscow in 2014.
After the start of Russia’s occupation of Ukraine’s Crimea and the Kremlin’s military intervention in the Donbas that year, Ukraine’s dependence on Russian gas became a security risk for the country.
Meanwhile, deteriorating relations with Kyiv made Nord Stream 2 a more expedient project for Moscow.
In November 2015, Ukraine stopped purchasing gas from Russia, and began importing it from Europe in a process known as “reverse flow.”
However, while these gas molecules are contractually European, they are geologically Russian — sold to Kyiv after being transported from Russia through Ukraine’s vast network of pipelines. Real energy independence will require something more than reverse flow, particularly with Nord Stream scheduled for completion in 2019.
Ariel Cohen, an expert on energy security affiliated with the Atlantic Council, suggests the current Ukrainian pipeline system helps prevent an all-out war between Ukraine and Russia. If Nord Stream and TurkStream come into operation, “Russia can do in Ukraine whatever it wants and not suffer any serious economic consequences,” Cohen said at a conference in Washington on June 14.
Yuriy Vitrenko examines one of over 100 tomes that make up Naftogaz’s international arbitration case against Russian state-controlled gas company Gazprom. (Kostyantyn Chernichkin)
Steps to reform
Dealing with the Russian threat thus means reforming the gas sector. But, for a country used to years of cheap gas and reliable transit fees, that means both clearing out entrenched interests, and making ordinary households pay a more realistic, market-based price.
In May 2015, Ukraine passed the law “On the Natural Gas Market,” which would help to create a competitive gas market based on EU legislation.
The law was one of the requirements Ukraine had to meet to receive aid from the International Monetary Fund.
This is one of several important steps Ukraine has taken since 2015, says Gennady Kobal, director of the ExPro consulting firm.
Ukraine has rapidly increased gas imports from Poland, Slovakia, and Hungary. And, in 2016, the Cabinet of Ministers launched a program to ratchet up domestic gas production from roughly 20 billion cubic meters to 27.6 billion cubic meters by 2020.
This year, Ukraine decreased taxes on new gas wells from 29 percents (for wells less than 5,000 meters deep) and 14 percent (for wells below this depth) to 12 and 6 percent, respectively — a move intended to stimulate exploration and investment in the sector.
“From the legal point of view, Ukraine has done a lot,” Kobal says.
But breaking its dependence on Russian energy has proven easier for Ukraine on paper than in reality.
The 2020 domestic extraction goal is now clearly impossible. Extraction is growing slowly, while investment remains limited. Kobal believes the sector suffers from a lack of equipment, specialists, and technology.
More concrete reforms have also proven elusive. In March, Prime Minister Volodymyr Groysman delayed increasing the price of gas for household consumers to market levels, a condition for International Monetary Fund financing.
Ukraine’s artificially low gas prices benefit corrupt business people, who buy domestic gas and resell it at market levels.
Plans to unbundle gas distribution company UkrTransGaz from Naftogaz in line with the European Union’s Third Energy Package also appear to have stalled.
In April, Naftogaz CEO Andriy Kobolyev requested that Groysman delay unbundling for two years, until the company’s contract with Gazprom — which it is required to complete under the Stockholm arbitration — concludes.
The next reform set to come into force is daily balancing, which will allow gas trading using daily — rather than monthly — contracts. If that doesn’t happen, it will mean “reforms of the market have stopped” and Naftogaz has come into conflict with the state energy regulatory commission, Kobal says.
“That’s a very bad signal because these are the structures that should pull the market along.”
He predicts daily balancing won’t happen in August.
Inside Naftogaz
Kobal’s prediction is a likely outcome, according to Yury Vitrenko, Naftogaz’s business development director.
But the shortfall isn’t Naftogaz’s fault, Vitrenko says.
Rather, his team has been fighting for reform, but has not always been successful going up against entrenched corruption. After Ukraine passed the 2015 “Natural Gas Market” law, its next step was to develop secondary legislation.
Vitrenko’s team pushed for Ukraine to adopt European network codes, including daily balancing, which govern Europe’s electricity market. Locally produced norms could include loopholes and exceptions that would allow vested interests and corruption to remain in Ukraine’s energy market, Vitrenko says.
But Ukraine’s energy regulator and regional gas distribution companies, largely controlled by natural gas oligarch Dmytro Firtash, insisted on adopting Ukrainian norms. “We’ve been fighting — and now it’s for more than four years — to adopt a truly European network code,” Vitrenko told the Kyiv Post.
In June, the Ukrainian government appointed a new regulator, Oksana Kryvenko.
Now, Naftogaz is appealing to her to implement the European network codes. Vitrenko says his hands are even more tied with unbundling. In order to separate UkrTransGaz from Naftogaz, the company must amend its transfer contract.
However, as early as 2014, Gazprom refused to amend. Naftogaz then asked the European Commission to make Gazprom amend the contract, but it directed the Ukrainian state company to arbitration.
And the international arbitration tribunal claimed to have no jurisdiction over the matter. “The only stakeholder who can do it is the European Commission, but they’re not doing it,” Vitrenko says.
“You either make Gazprom amend the contract and play by European rules, or it leads to the delay in unbundling.” Ukraine’s only leverage would be halting transit to force Gazprom’s hand, Vitrenko says.
But Europe opposes this move, and it would both damage Ukraine’s reputation as a reliable partner and likely increase support for Nord Stream 2.
Little sympathy
Few energy experts support Vitrenko’s claims. ExPro’s Kobal believes time is of the essence in Ukraine’s energy reforms.
“We can’t constantly put things off,” he says. “We need to do as much as possible before elections.” And the Atlantic Council’s Cohen sees little reason why the Stockholm decision should affect unbundling.
The politically connected state-owned company’s role as an oil and gas monopoly and involvement in exploration creates room for corruption, he says.
Cohen also believes Ukraine should change its tariffs to attract investment, improve conditions for alternative energy, and better maintain and renovate the country’s massive nuclear power potential. Finally, it should regularize its purchases of coal and find a supplier other than Russia.
CSIS’s Chow suggests that Ukraine must urgently increase domestic gas production. But the conditions for this are poor.
Domestic production has long been stuck at roughly 20 billion cubic meters annually, and there haven’t been tenders for new exploration licenses in two years, he says.
That’s not because of unfavorable geology: in the 1970s, Ukraine produced over 70 billion cubic meters — enough to cover its consumption needs, with some left over to be exported to other Soviet republics.
Rather, the problem is corruption. “It’s all a system wired for insiders,” Chow says.
Without reform, no one will invest unless they feel they have “insider help.” But with reforms largely stalled, Chow sees only one solution in Ukraine: tough love from the international community. “As I always say to the IMF people, the time to get tough is on the first (aid) tranche, not the third.”
